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My latest stop in my mythic Campbellian heroic quest to argue with literally anyone who favors the Volcker Rule on the internet brings me to this week-old Bloomberg editorial by some guy from “Better Markets Inc”, a nonprofit which (as far as I can tell) exists for this guy and/or whoever he hires to send out editorials pretty much like this. (Which gives me an idea for my next ‘career’…)
It purports to describe what’s wrong with the Volcker Rule and how to fix it. The interesting thing is that the authors more or less correctly perceive the overall problem with the Volcker Rule approach; if you just ignore their ‘solutions’ much of the piece works quite well as a 10,000-foot aerial view of why the Volcker Rule is so idiotic.
Before we get to that though it’s worth mentioning that on some level – unless they were trying to dumb it down for the Bloomberg audience (?) – they don’t seem to really know the subject they purport, and presumably pay themselves, to publicly opine on. In their example description of ‘prop trading’ we get this:
…he could use the bank’s borrowing ability to acquire 1,000 bonds at $100 apiece, for a total of $100,000.
Now maybe I just move in the wrong circles but seems to me nobody speaks about bonds this way. Presumably (although technically the weird language makes it impossible to say) this example involves someone buying $100,000 notional or face value or principal or par value worth of bonds, for a bond price of 100% or of par or 100 points or 100 cents on the dollar. Any permutation of the preceding terms would be a, like, normal way of talking about buying bonds. I have never, meanwhile, heard such a thing referred to as buying “1,000 bonds” at “$100 apiece” (meaning each “bond” is $100 notional? if anything, isn’t $1000 the generic bond-size / minimum increment?). This ‘buying N things for $X apiece’ stuff is how you speak about stocks and other equity-like things, not bonds. Now sure in the grand scheme this is basically a minor miscue in lingo and their larger point is unchanged, but shouldn’t the Better Markets people be, like, at least passingly familiar with the Markets they are busy Bettering with their Market expertise?
Anyway, I do want to give credit where credit is due and point out that the core of their critique of the Volcker Rule is right on the money. This is a great way of describing the difficulty in trying to distinguish market-making from prop trading:
…regulators would be forced to reconstruct history to counter claims by traders and their lawyers that their money-making positions really were necessary inventory or hedges; that market circumstances really were unusual; or that in the long term their income really was “primarily” from acceptable sources. This is a prescription for endless and fruitless Whac-A-Mole forensics.
The reason such forensics will be difficult and Whac-A-Mole of course, is because – for the zillionth time – there’s no sharp dividing line between ‘market-making’ and ‘prop trading’ in the first place. If there were a sharp distinction, ‘forensics’ to suss it all out wouldn’t be necessary! But instead of following this to its logical conclusion (=it’s silly to care about trying to carve out and ban ‘prop trading’ per se, as opposed to focusing on controlling/limiting actual risk), the authors go off the deep end and try to ban – though maybe they don’t realize it – virtually all trading:
For example, the rule must presume that only trading activity producing income from actual and observable spreads — brokerage fees and commissions are suitable alternatives — is true market making. This means that a trader who takes a successful speculative position, whether it was designated as client inventory or as a hedge, cannot claim he is earning money from market making.
What they’re suggesting, if they’re saying anything, is to treat profit & loss from only instantaneously-crossed trades/some ‘observable’ bid-offer (as if it is so well-defined) as ‘market-making’, but all other gains/losses as ‘prop trading’ (and thus counted as banned/limited activity) regardless of intent. Now, how exactly one is supposed to split out bid/offer from short-term price movement, I’m sorry to report, will still require ‘forensics': if I buy for 100 and sell for 102 within X minutes of each other, was that a 2-point bid-offer I just captured? Or did the price ‘move’ by 2 points in those X minutes? Or was it some combo? And doesn’t it depend on X? If so, what’s the cutoff/relationship? That aside though, this proposed method of splitting trading into prop and non-prop has the virtue that it is (relatively) tractable and objective, rather than impossible and arbitrary (as with the Volcker Rule’s split). The problem, if it is one, is that by such a rule almost all trading would involve ‘prop trading’ since (as explained in the Morgan Stanley comment letter they cite) normal market-making, aside from a few highly-liquid products, involves possibly holding positions for a while, before finding the other side.
In their example – which is almost identical to mine – they ask us to imagine a (1) market-maker who buys a bond for $100 and (2) prop trader who buys a bond for $100. Right away you might notice a, er, similarity here. How are we, and more importantly Volcker-enforcers, supposed to tell those transactions apart? Well, the authors imagine that the market-maker automatically exits his position (instantaneously?):
They typically try to sell after they buy, and buy after they sell, avoiding the risk of harmful price changes by hedging and keeping inventories small. […] For example, on any given day, a market maker may offer to buy a corporate bond for $100 and sell the same bond for $102. The $2 difference on the round trip is the bid-ask spread — and the source of the market maker’s revenue.
Right right, that’s all well and good, but what if the market-maker doesn’t find a buyer at $102 right away? Remember, this is a possibility, by definition, since (everyone agrees, including these guys) that a market maker “stand[s] ready to buy or sell some financial instrument, often by providing bid-and-ask prices at which they are willing to trade”. ‘Standing ready’ to buy a bond you aren’t short means you could end up with the position yourself. I mean, duh.
In which case the market-maker is holding a bond that he bought for $100, just like the ‘prop trader’. He would like for the bond’s price to rise while he’s holding it, just like the ‘prop trader’, because that would make him money, just like it would the ‘prop trader’. He will look for someone to sell it to later for a higher price, just like the ‘prop trader’. Why, it’s almost as if there’s no meaningful economic difference between these two guys’ positions!
The thing to keep in mind is that this is what happens, like, all the time. The problem is that there are people who subscribe to the standard economist model of trading and thus, on a very basic level, don’t seem to understand this fact. Absent other info it looks like Better Markets, Inc. may be among those people, because they speak as if expanding ‘prop trading’ to include price-movement on market-making inventory would just be a minor, simple adjustment to the Volcker Rule. When in reality, it would probably effectively restrict 90% or more of all trading. Whether they’re unaware of this, or aware of it (because that’s their intent), is an open question. But given that their other suggestion involves ‘financial penalties that are multiples of the gain from violating the rule, and must be assessed on the individuals, supervisors and executives’ – in other words, penalizing individual employees if they do a supposed-to-not-be-‘prop’ trade that ends up making money over a too-long time frame (I guess), I think it’s fair to say that their proposal is either not serious or, if it were possible to take and implement such a policy literally, would indeed squash most trading.
Which is to say, that ‘better markets’ turns out to be, to a large extent, no markets.
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