The Volcker Rule has banned proprietary trading of banks with access to official backstops. Also, market making has become more onerous as restrictions and ambiguities of the rule make it harder for dealers to manage inventory and to absorb large volumes of client orders in times of distress. This increases liquidity risk, particularly in market segments with longer turnover periods, such as corporate bonds. A new empirical paper confirms that the Volcker Rule has indeed reduced corporate bond liquidity and aggravated the price impact of distress events, such as significant rating downgrades.

Bao, Jack, Maureen O’Hara, and Alex Zhou (2016). “The Volcker Rule and Market-Making in Times of Stress,” Finance and Economics Discussion Series 2016-102. Washington: Board of Governors of the Federal Reserve System.

The post ties in with the lecture on price distortions on this site and particularly the subject of liquidity risk.

The below are excerpts from the paper. Headings and some other cursive text has been added for context and convenience of reading.

The basics

“As part of the Dodd-Frank Act, passed July 21, 2010, section 13 (the “Volcker Rule”) was added to the Bank Holding Company Act of 1956…The intent of the Volcker Rule is to prohibit banking entities with access to the discount window at the Federal Reserve or to FDIC insurance from engaging in risky proprietary trading.”

“Implementation…was not immediate and followed a laborious process…Final regulations with details of market participants’ comments were released…on January 31, 2014. On April 1, 2014, the Volcker Rule became effective with banks of at least USD50 billion in trading assets required to report some quantitative metrics starting July 2014. By July 21, 2015, large banks were required to be fully compliant with the Volcker Rule.”

“Not all trading activities are precluded. Recognizing that some activities are necessary for the market to function normally, the Volcker Rule includes…a provision that permits market-making. Essentially, affected dealers can trade securities in a way to facilitate client-driven transactions, but cannot transact in a way intended to make profits based on the price appreciation of securities…The Financial Stability Oversight Council proposed a number of principles to distinguish between the two. Among these are that market-making should have rapid inventory turnover with the vast majority of profits from bid-ask spreads rather than profits from inventory appreciation.”

The problems

“Critics of the Volcker Rule noted many gray areas in the rule and further argued that ambiguity in how the rule would be enforced was likely to be detrimental to market liquidity…Ambiguity as to what is legal market-making and what is prohibited proprietary trading may [be]…pushing dealers toward more conservative trading strategies. New rules favoring customer-facing trades may discourage dealers from using the interdealer market, while inventory-based metrics may lead dealers to reduce their inventory exposure…Dealers who fear violating the Volcker Rule could be unable to properly manage inventory. One of the guidelines for the Volcker Rule is meeting ‘near-term customer demand.’ But absent perfect predictions about future customer demand, market makers may be hesitant to acquire bonds in advance of a predicted spike in customer demand.”

The requirement that dealers set internal limits may result in dealers being unable to respond to increased customer demands during times of stress… Instead, a banking entity is required to have escalation procedures that include ‘demonstrable analysis and approval.’ Such regulations mean that market makers will find it particularly difficult to respond to large sells in the market.”

The Volcker Rule could be particularly problematic in illiquid markets such as corporate bond markets…Whereas the average half-life of order imbalance in equities is three days, for investment grade corporate bonds it is roughly two weeks. Thus, metrics based on measures such as inventory aging and inventory turnover could be particularly problematic for market-making in corporate bonds.”

“Fully understanding the impact of the Volcker Rule on market liquidity requires understanding how liquidity behaves in the face of severe conditions, or exactly when liquidity is needed most…Practitioners and policymakers alike have noted that illiquidity in times of market stress may be the more relevant metric for gauging market stability and performance.”

The evidence

“The evidence in our study suggests that there are significant costs to the proprietary trading ban in the Volcker Rule.”

“Our main finding is that the Volcker Rule has a deleterious effect on corporate bond liquidity and dealers subject to the Rule become less willing to provide liquidity during stress times. While dealers not affected by the Volcker Rule have stepped in to provide liquidity, we find that the net effect is a less liquid corporate bond market…Dealers affected by the Volcker Rule see a statistically significant increase in agency trades, or trades in which the dealer has pre-arranged an offsetting trade so as not to have inventory risk. For non-Volcker dealers, we see no such effects on agency trades in the post-Volcker period. We also find that Volcker-affected dealers significantly reduce their capital commitment.”

“Since Volcker-affected dealers have been the main liquidity providers, the net effect is that bonds are less liquid during times of stress due to the Volcker Rule.”

“Our study focuses on events where investment-grade bonds are downgraded to speculative grade to capture plausible events of forced selling. Using these stress events, we find that downgraded bonds exhibit a larger price impact of trading than a control group of BB bonds. More importantly…our results show that bond liquidity deterioration around rating downgrades has worsened following the implementation of the Volcker Rule…The relative level of the excess price impact is larger after the Volcker Rule is implemented than the period just before the Volcker Rule is implemented. Indeed, we find the disturbing result that illiquidity in stress periods is now approaching levels see during the financial crisis.”

“Our focus is on a difference-in-differences test comparing the illiquidity of downgraded corporate bonds to a baseline control group both before-and-after the Volcker Rule was implemented.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.