As the old adage goes, be careful what you ask for, you might just get it. After the 2008 crisis it became fashionable to complain that too much trading is going on. There were calls in this and other countries to restrict financial transactions. And it happened. One example is the rule named after Paul Volcker in the 2010 Dodd-Frank law, banning depository banks’ trading on their own accounts (and also forbidding them from holding significant hedge fund or private equity interests).
Regulators are still in the process of determining how to implement the Volcker rule but the potential impact is already discernible. Likely victims include millions of Americans who save for their retirement and smaller companies that need to borrow money.
Banks are shutting down their proprietary trading. You may believe that is all for the best. But as people warned back when the Volcker rule first came up, there is no clear demarcation between prop trading and market making for clients. Regulators propose intricate sub-rules to make the distinction but it the end it will come down to their judgment, meaning that banks trading for clients will be in danger of violating the no-prop-trading rule. Given the legal risk, they’re reducing their market making.
The consequence is that there are fewer market players to match buyers and sellers. This is a particular problem in the bond market, which is not as deep as the stock market. It is becoming harder to buy or sell bonds. The effects can be wide-reaching.
Mutual funds managers are concerned that transaction costs will rise. The Volcker rule as written could impede market making and raise transaction costs, says Karrie McMillan, general counsel to the Investment Company Institute, the mutual fund trade organization. It is hard to imagine what fixed income markets will look like if the rule goes into effect as proposed, she said, speaking at an ICI conference.
Mutual funds cannot be brushed aside as serving the 1%—on the contrary, most Americans who save for their retirement invest via mutual funds. Higher transaction costs translate to lower returns on retirement savings. So Dodd-Frank, if the rules are implemented as proposed, will in effect rob nest eggs.
Another consequence concerns businesses, in particular smaller companies. A report from Barclays Capital on the credit outlook contains a telling graph: turnover in investment-grade bonds is down for smaller deals while it is up for over-$1 billion deals. That is, liquidity is evaporating for smaller issues.
With various regulatory changes in the works, including the Volcker rule and Basel III, dealers are not making markets, says Jeffrey Meli, head of global credit strategy at Barclays Capital.
As the secondary market for bonds becomes less liquid, potential bond investors face additional risk especially with smaller company debt. If they need to sell, what will the market for the bonds be like? Mr. Meli said this is a time of transition but small and infrequent debt issuers could face a permanently higher liquidity premium.
In other words, Dodd-Frank is making it more expensive for smaller businesses to borrow. That can’t be the way to a stronger economy. It certainly is not the way to encourage job creation.
Did members of Congress and the Obama administration do this because they do not understand what they’re doing? Or was it a deliberate shenanigan to serve some political or personal interest? Put simply, are they fools or knaves?
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