A look at the Volcker Rule's impact on market liquidity

A new opinion piece from Woodbine Associates published on April 4, 2012 “Beyond Volcker:  Seeing the Forest through the Trees” caught our eye. About half-way into the piece the author addresses the impact of the Volcker Rule on market liquidity.

The results include wider bid-ask spreads, dealers taking on less inventory, and diminished ability to execute large size trades. “….Transaction sizes should fall and volume should increase as customers take on more execution risk…Those firms seeking instantaneous liquidity for trades that significantly exceed normal market sizes will pay more for it.  Others will be more likely to hold and execute risk over longer periods and will seek other sources of liquidity and new trading venues…”

That last part – about other sources of liquidity — is interesting. Woodbine predicts that non-bank entities, like regional dealers and hedge funds, will play a greater role in the markets. That rings true to us but raises some big issues too. Will the Volcker Rule act as an enabler to push the risk into the so-called “shadow banks”? Some regulators have expressed concern about the new regulatory world doing just that. You can’t have it both ways.

Those regional dealers and, in particular, hedge funds will have to finance themselves somewhere. They will go to the big banks and broker/dealers and execute repos. Those deals will be customer flows and should be allowable under Volcker. But isn’t the outright prop risk just being substituted for financing risk? The latter has been known to be somewhat opaque (well, maybe the former too).  Since there is an extra layer taking out a spread, costs will go up, liquidity down. We are not sure if this doesn’t set the market up for an unintended consequence down the road.

If the effect is to disperse the risk to lesser capitalized players, has the rule swapped “too big to fail” for greater risk of multiple smaller failures? Repos, and financing in general, have been an excellent transmission mechanism of systemic risk, traveling back up the wire back to the big banks.

A link to the article is here.

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