Market Making or Proprietary Trading: Volcker distinction

Source : Duffie, Darrell , Market Making Under the Proposed Volcker Rule (January 16, 2012). Rock Center for Corporate Governance at Stanford University Working Paper No. 106.

Also available at SSRN: http://ssrn.com/abstract=1990472  or http://dx.doi.org/10.2139/ssrn.1990472

In a section of the Dodd-Frank Act commonly known as “the Volcker Rule,” Congress banned proprietary trading by banks and their affiliates, but exempted proprietary trading that is related to market making, among other exemptions.

Proprietary trading is the purchase and sale of financial instruments with the intent to profit from the difference between the purchase price and the sale price.

Market making is proprietary trading that is designed to provide “immediacy” to investors. For example, an investor anxious to sell an asset relies on a market maker’s standing ability to buy the asset for itself, immediately. Likewise, an investor who wishes to buy an asset often calls on a market maker to sell the asset out of its inventory. Market makers handle the majority of trading in government, municipal, and corporate bonds; over-the-counter derivatives; currencies; commodities; mortgage-related securities; currencies; and large blocks of equities. (The Volcker Rule exempts currencies, United States treasuries, federal agency bonds, as well as certain types of state and municipal bonds.) Most market making, both in the U.S. and abroad, is conducted by bank-affiliated broker-dealers. [Page 1]

Market making is inherently a form of proprietary trading. A market maker acquires a position from a client at one price and then lays off the position over time at an uncertain average price. The goal is to “buy low, sell high.” In order to accomplish this goal on average over many trades, with an acceptable level of risk for the expected profit, a market maker relies on its expectation of the future path of market prices. Future prices are uncertain because of unforeseen changes in economic fundamentals and market conditions. The length of time over which a position must be held is subject to the unpredictable timing and direction of client demands for immediacy. These risks vary significantly across time because of changes in market volatility and significant variation in the sizes of positions that market making clients may wish to acquire or liquidate. [Page 3]

Inventory Risk Management

When a market maker serves a client’s demand for immediacy its inventory often moves away from a desired target level. If the inventory is abnormally high or low, the market maker typically shifts its bid and asks quotes with the goal of moving its inventory back toward its target over time. The market maker may wish to accelerate the reduction of an inventory imbalance, lowering its risk, by requesting trades from others, including other market makers. Inventory risk management includes hedging with related financial instruments.

In the meantime, the market maker continues to absorb supply and demand shocks from its clients. The general objective is to buy low and sell high, balancing the risk of loss against expected profit. [Pages 7-8]

Distinguishing Proprietary Trading from Market Making

For example, at page 94 of PROHIBITIONS AND RESTRICTIONS ON PROPRIETARY TRADING AND CERTAIN INTERESTS IN, AND RELATIONSHIPS WITH, HEDGE FUNDS AND PRIVATE EQUITY FUNDS (http://www.sec.gov/rules/proposed/2011/34-65545.pdf), immediately before this characterization of market making, one reads: “The Agencies expect that these realized-risk and revenue-relative-to-realized-risk measurements would provide information useful in assessing whether trading activities are producing revenues that are consistent, in terms of the degree of risk that is being assumed, with typical market making related activities.” At page 92, the Agencies suggest they will use the proposed risk metrics to “to determine whether these activities involve prohibited proprietary trading because the trading activity either is inconsistent with permitted market making-related activities or presents a material exposure to high-risk assets or high-risk trading strategies.” At page 93: “Significant, abrupt or inconsistent changes to key risk management measures, such as VaR, that are inconsistent with prior experience, the experience of similarly situated trading units and managements stated expectations for such measures may indicate impermissible proprietary trading.” [Pages 18-19]

Robust capital and liquidity requirements

Leading up to the financial crisis of 2007-2009, the regulatory capital and liquidity requirements of financial institutions were clearly insufficient. These requirements should continue to be strengthened as deemed appropriate by regulators to robustly protect the Deposit Insurance Fund and the soundness of the financial system.

In any case, whether market making is conducted by banks or others, market makers should be required to meet robust capital and liquidity requirements. A crucial point is that the market making and other risks taken by a financial institution are unsafe precisely when they are large relative to the institution’s capital and liquidity buffers. [Page 22]