The Volcker Rule Restrictions on Proprietary Trading

Implications for Market Liquidity
March 28, 2012
Industry Trends
North America

Abstract

REPORT PREVIOUSLY PUBLISHED BY OLIVER WYMAN

Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (commonly known as the Volcker Rule) was introduced into law in July 2010. The Volcker Rule was proposed as a means of ensuring the safety and soundness of the US financial system by restricting proprietary trading by US banking entities. The five regulatory agencies charged with implementing the statute have now released formal notices of proposed rulemaking that contain draft regulations implementing the Volcker Rule.

The central challenge presented by the Volcker Rule is differentiating prohibited proprietary trading from permitted activity related to market making. In Oliver Wyman's study, The Volcker Rule Restrictions on Proprietary Trading: Implications for Market Liquidity, we focus on one major aspect of this challenge--exploring the risk the proposed rule could pose to market liquidity by establishing a regulatory regime that directly or indirectly constrains dealers’ ability to make markets for their customers.

Oliver Wyman finds that the proposed rule represents a significant risk to market liquidity. We use the US corporate bond market as a case study to simulate the possible effects of an overly restrictive Volcker Rule regime, finding that a plausible reduction in dealers' ability to serve their customers would result in large costs to investors, issuers, and the economy as a whole. We then extend our discussion to parallel risks facing other asset classes and make a set of recommendations to guide policymakers in navigating the critical implementation period to come.

Celent is a research and advisory firm dedicated to helping financial institutions formulate comprehensive business and technology strategies. Celent publishes reports identifying trends and best practices in financial services technology and conducts consulting engagements for financial institutions looking to use technology to enhance existing business processes or launch new business strategies. With a team of internationally based analysts, Celent is uniquely positioned to offer strategic advice and market insights on a global basis. Celent is a member of the Oliver Wyman Group, which is part of Marsh & McLennan Companies [NYSE: MMC].

Media Contacts

North America (Boston)
Erica Ferguson
eferguson@celent.com
Tel.: +1 617 262 8225

Europe (London)
Chris Williams
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Tel: +44 (0)208 870 7875

Asia (Tokyo)
Yumi Nagaoka
ynagaoka@celent.com
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Table of Contents

1. Background and purpose of this study

1

2 Summary findings

2

3. Impact on the US corporate bond market

7

 

3.1. The value of the principal market making model

7

 

3.2. Potential effects of the proposed Volcker Rule on liquidity

10

 

3.3. Impact on investors, issuers, and the roader economy

19

4. Considerations for other asset classes

26

 

4.1. Liquidity effects and economic impact across markets

26

 

4.2. Cash Equities

29

 

4.3. Foreign Government Debt

32

5. Recommendations for policymakers in implementing the Volcker Rule

36

Appendix A: Definitions of proposed Customer-Facing Activity Measurements

38

Appendix B: Detailed methodology

40

 

B.1. Impact on the US
corporate bond market

40

 

B.2. Considerations for other asset classes

43

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