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Regulation

Volcker changes might have little impact with Basel III still around

Anthony J. Perrotta Jr.
Anthony J. Perrotta Jr. doesn’t think scaling back Volcker will alter much.

Rolling back some elements of the Volcker rule that target fixed-income markets might make headlines, sources said, but liquidity and trading costs won't improve in the corporate bond market because Basel III requirements aren't going away.

"I think people have misinterpreted the impact of the Volcker rule," said Anthony J. Perrotta Jr., CEO of TABB Group LLC, New York. "While the Dodd-Frank Act and the Volcker rule capture a lot of headlines, their impact on bond market liquidity and trading has been marginal relative to the capital adequacy requirements" of Basel III's liquidity coverage ratio. "You can repeal Volcker tomorrow and I am not certain anything would change, or banks would act differently."

Added Adam Sussman, head of market structure and liquidity partnerships at Liquidnet Holdings Inc., New York, "The Volcker rule isn't the be-all or end-all. On the institutional side, there's bigger fish to fry. The negative impact of Volcker is less on market making and liquidity and more on the entities — especially smaller banks — that were forced to comply with a rule over practices that they didn't engage in."

The Volcker rule, proposed by former Federal Reserve Board Chairman Paul Volcker as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, banned U.S. banks from certain speculative investments and most proprietary trading deemed not in their customers' interest. On June 13, the Treasury Department in a report called for "substantial amendment" to the Volcker rule, including not subjecting banks with less than $10 billion in assets to it, and removing proprietary trading restrictions on larger banks, allowing them to "more easily hedge their risks and conduct market-making activities."

On Aug. 2, the Office of the Comptroller of the Currency announced it was seeking public comment on possible changes to the rule. The OCC is one of five federal agencies charged with enforcing the rule, along with the Federal Reserve, the Commodity Futures Trading Commission, Federal Deposit Insurance Corp. and the Securities and Exchange Commission.

While the Volcker rule's reach extends to proprietary trading in a variety of securities, derivatives, commodity futures and options, fixed-income investors were particularly concerned when the rule was imposed that it would dry up secondary liquidity at a time when bonds were already hit by low rates. But Volcker as well as Basel III regulations in total have not stopped the availability of fixed-income securities on the secondary market. SEC economists in a report issued Aug. 8 said there hasn't been a decline in total issuance of securities since the enactment of Dodd-Frank. But they have made trading those securities much more expensive — particularly for ​ hedging transactions commonly made by pension funds. Amending the Volcker rule won't change that.

"The jury is out whether the Volcker rule has any impact on markets," said Mr. Perrotta, "but there is no denying Basel III has reduced risk and leverage. The industry has reduced its capital leverage from roughly 30-to-1 in 2007 to about 7-to-1 in 2017."

Higher cost of capital

Several large money managers and pension funds contacted for the story would not comment, with one pension plan spokesman saying they "do not theorize, make projections or otherwise expound on public policy issues of this nature."

Mr. Perrotta said the liquidity coverage ratio, emanating from the Basel III accords, requires banks to hold a specific amount of high-quality liquid assets, creating higher standards for banks and driving the cost of capital higher. According to the website of the Bank for International Settlements, whose Basel Committee on Banking Supervision created Basel III, banks must have enough high-quality liquid assets that can be converted immediately into cash to meet their liquidity needs for a 30-day liquidity stress scenario incorporating events of the financial crisis of 2007-2009, reaching 100% of liquidity needs by 2019.

William C. Slaughter, partner and senior portfolio manager at Northwest Passage Capital Advisors LLC, Milwaukee, said the higher cost of hedging has hurt pension funds in particular. He said that as of Aug. 10, the 30-year Treasury swap spread was -32 basis points; in 2007, that spread was 60 basis points.

"Since the financial crisis, there's been a swing of 100 basis points — and most of that has been paid by the pension fund," said Mr. Slaughter, whose firm manages $1 billion in active investment-grade emerging markets fixed income for institutional investors. "Post-financial crisis, dealers are still happy to do this, but the capital cost of putting on a hedge is reflected in the cost of the swap spread.

"It's business the banks don't want any more… But a well-managed pension fund needs these hedges. This costs them money. Does it make the financial system safer, to take money out of the pockets of pension funds when these things didn't cause the financial crisis?"

Liquidnet's Mr. Sussman agreed. "If some companies have left the (derivatives) business because of capital requirements, that's less competition, higher costs, and the remaining banks pass on that cost of capital to pension funds and other clients. It's not clear changing Volcker alone would change that."

Mr. Slaughter said Basel III and the LCR "have a bigger impact on fixed-income derivatives and the cash market. There's just not enough volume available to handle the size big institutions use. The over-the-counter swap market usually requires banks to hedge the risk with cash securities. But capital requirements have all made the cost of balance sheets too expensive. If you free up the bank balance sheets, I'm convinced negative swap spread would go to zero or even positive."

Duplication

Regulations like Volcker and Basel III were created "so that financial firms can continue to do business notwithstanding any interruptions," said Ralph M. "Chip" MacDonald III, partner at the law firm of Jones Day in Atlanta. "That was sort of the purpose for liquidity rules. But higher payments — what economists refer to as 'friction' — make it costly to mitigate risk, which makes the market less efficient, more expensive and less liquid."

Mr. MacDonald also said there is duplication in the regulations. "Part of the problem is there are multiple solutions for the same issue," Mr. MacDonald said. "There are capital rules, and those are layered into the Volcker rule; but you also have Federal Reserve rules and Basel III. So you have three different things aiming for the same solution. So why do you need the Volcker rule?"

As for the proprietary trading ban, Mr. Perrotta said the restriction on banks from trading for their own account to profit from short-term price movements is "both vague and ambiguous because (the proprietary trading ban) allows market-making and the temporary warehousing of risk to facilitate customer demand. Overall, the market has seen minor changes to the way banks are operating their bond trading businesses. Banks are committing less balance sheet to secondary market-making businesses today than before the crisis, but this may be a function of lower rates, tighter spreads and the credit cycle as much as it is a response to regulation."​

The top 20 underwriters of U.S. corporate bond debt provide about $105 billion of balance sheet capacity for secondary market-making services, down from $160 billion in 2006, according to an upcoming TABB Group report.

Brian Svendahl, managing director and co-head of U.S. fixed income with RBC Global Asset Management (U.S.) Inc., Minneapolis, said proprietary trading desks helped improve liquidity. "They were the opportunistic bid in times of stress and offer, when paper was hard to find," Mr. Svendahl said. "You might not like their levels, but they were additive to depth."

However, Mr. Svendahl said it's "inconclusive" whether relaxing the ban on proprietary trading would lead to improved returns. "Fixed-income returns are dominated by macro events and overall level of rates while improved liquidity is more of a short-term aspect," he said. RBC Global U.S. had about $10 billion in fixed-income assets under management as of Dec. 31, according to Pensions & Investments data.