The Nature of Liquidity
Big banks love to complain about the Volcker Rule — the provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act that prohibits federally subsidized and insured banks from engaging in risky proprietary trading and from betting against their own customers — and they are adept at generating clever, head-spinning arguments to oppose it. The latest involves European government bonds.
According to a Financial Times article Nov. 21, bankers warn that this new provision of the Dodd-Frank Wall Street Reform Act would reduce “liquidity.” “Bankers and traders say that ‘prop’ trading – trading on banks’ own accounts – is a big part of the U.S. presence in the $13,000bn eurozone debt market.” If U.S. banks can’t pursue short-term profit from trading actively in European debt, the argument goes, then European governments will be hurt. Europe needs more people buying their debt, not fewer.
The basic problem with this argument is that it conflates short-term speculation and true demand. European governments might need more demand for their debt, but they don’t need U.S. banks churning and speculating on it — and the latter is what the Volcker Rule would stop. Let’s unpack the argument a bit.
The Volcker Rule ban on speculation should be welcome in the market for European sovereign debt because it directs banks to hold assets so as to profit from interest as opposed to short-term price changes. That will make banks patient investors in European debt, increasing demand and improving “liquidity” (which means making it easier for sellers of European bonds to find buyers).
When banks engage in short-term speculation, at best the effect on demand is neutral. After all, a bank’s trade should net out, with the bank selling as often as buying. The Volcker Rule does permit market making, which is the intermediation between willing buyers and sellers of the same financial position. In a sense, prop trading and legitimate market making depend equally on the presence of buyers and sellers. The market maker requires clients on both sides of the bond transaction. Similarly, the prop trader won’t take a position unless confident of resale. The Volcker Rule simply prohibits the bank from charging a price beyond a commission for that intermediation. (The commission may be expressed in the bid-ask spread, or an advertisement that the market maker holds itself out as willing to buy for a little less than it will sell the same financial instrument.) This prohibition should appeal to customers and generate additional market making business revenue for the bank. Who prefers a bank that may bet against its own customers?
If liquidity means what it usually means — the ability to sell a particular financial instrument without changing its price — then legitimate market making permitted by the Volcker Rule should reduce volatility. While the prop trader may “hold out” for a price increase, or “stay out” until the price craters, the Volcker Rule market maker will be obliged to buy and resell continuously at a posted price spread.
If liquidity simply equates with trading volume, American banks will be inactive as prop traders when the Volcker Rule is well enforced. Is that bad? If U.S. banks will only buy and sell European government bonds as speculators that highlights a far worse problem than liquidity; it signals that banks may believe European debt doesn’t count as a prudent, long term investment.
Financial regulators must not be confused by bank sophistry as they accept public comments on their proposed draft of the Volcker Rule through January 13, 2012.