Monday, March 5, 2012

Verbatim: "Not What They Were Designed For"

From Jeff Carter at Points and "... in Senate testimony, Senator Corker asked a lot of questions of Bernanke on the Volcker Rule. In essence, he was asking broad questions about market making that have little or no relation to what the Volcker Rule’s actual intent was. Corker was trying to build a case that the banks should be allowed to trade, based on their market making capabilities. I have a few perspectives on that to share. First, if the banks didn’t make markets, what would happen? If there was value to making those markets, someone would step into the void. I can recall in a trading pit when a big trader would retire, or take a vacation, people ask, “Who will pick up the slack?” Without fail and immediately, someone would. Financial markets are highly competitive. If banks weren’t making markets someone would. Another perspective is this. In the early 1990′s, we did a survey of the largest volume traders in the Eurodollar pit at the CME. There was a lot of controversy between locals and order fillers because locals thought that order fillers were stealing trades from them. In fact, when the data poured in, it turned out that something like 15 of the top 20 traders in the pit were order fillers. Most of them were simply trading against their decks. Eventually we banned dual trading and volume actually increased. The market didn’t skip a beat. Think of everyone as a local, and the banks as order fillers in this illustration. Banks use their market making function to trade against their customers and earn relatively risk free profits. That’s not what markets were designed for. I maintain that if you took the proprietary trading function away from banks, the market wouldn’t miss a beat and we might actually see an increase, not decrease, in liquidity. The structure of the market place is wrong. Recall the financial melt down. It was shown that while Goldman was selling junk to their customers, their prop traders were taking the other side of that junk and reaping humongous profits. Nothing wrong with a profit, but they weren’t taking any risk. When banks and hedge funds are allowed to pay for order flow, internalize order flow, it messes with the integrity of the marketplace. I agree the Volcker Rule isn’t perfect. Actually, it’s been so defanged it won’t make much of a difference. What we ought to be doing is looking at the function someone is performing in the marketplace. If they are filling an order, they should be paid for that service-and not allowed to take the other side. If they want to trade and risk their capital, they shouldn’t be able to fill orders. It’s pretty simple."