Volcker Rule No Threat To ETFs

February 22, 2012

Ugo, my friend, despite your firsthand knowledge of ETF market making, I think you’re missing several key points on the pending Volcker Rule.

First, the intention of the rule isn’t to keep financial firms from trading with client’s money, or even the firm’s own money. The real intent is twofold: First, protect taxpayer funds; and second, protect the global financial system.

The Volcker Rule would eliminate one of the moral hazards at the root of the financial crisis—namely that big banks will take outsized risks because they know that taxpayer dollars will bail them out if their bets fail spectacularly.

As it stands now, if big banks take big risks and win, top management and shareholders benefit, which is fine. But taxpayers get no upside for their participation. If the big bets fail, taxpayers foot the bill while chief executives deploy their golden parachutes.

More importantly, the Volcker Rule tackles the current systemic threat: Uncle Sam’s downside protection encourages banks to take much larger risks than otherwise would – or should.

That’s the idea behind the Volcker Rule. Opponents raise a few key objections.

The first of these is liquidity. So-called proprietary trading or “prop” trading is one of the ways that banks make the big bets mentioned above. The argument goes that a reduction in prop trading will reduce overall trading volume so spreads will widen and transaction costs will increase, hurting investors of all sizes.

My point is that—gasp—the market will set the spreads: the real market, undistorted by any liquidity from prop trading. Put another way: If prop trading, backstopped by tax dollars, supports trading costs, then the Volcker Rule simply eliminates this de facto subsidy.

I would further argue that a slight increase in transaction costs would likely hurt the fast-money crowd more than retail investors or long-term players. I’m sure the smart money folks will survive—and home prices in Greenwich, Conn. won’t suffer too terribly.

My second point is thornier, to be sure: How should regulators draw the line between what’s prop trading and what’s a hedge.

I haven’t read the full text of the proposed law or the blizzard of responses posted during the comment period, but I’ll bet that of all the complexities surrounding this issue, ETFs are in the easy pile.

For ETFs at least, it’s not hard to picture a system based on value of the positions, not on the whether the market maker holds a particular security like XOM.

If a market maker needs to hedge “x” dollars of notional exposure, then their notional offsetting positions, on average, should roughly equal “x.” On the other hand, if their notional exposure is 20, 30 or 100 times what they’re supposedly hedging, then maybe they’re gambling with my money.

I’m sure its gets more complicated than this, but I‘m confident that the fine minds that created incredibly complex structured products are up to the challenge. And, if some of the smaller, illiquid funds don’t survive, or if the ETF industry only launches three new funds per week instead of five, well, that’s capitalism for you.

In my view, “Big Finance” should see the Volcker Rule as the lesser of two evils.

In the past, the United States has broken up industries that it believed had grown too big: railroads, oil firms and telecoms, to name a few. Uncle Sam’s tactical response in the dark days of 2008 was to make the big banks bigger, but don’t bank on that as being the government’s long-term strategic response.

In the grand scheme of things, the Volcker Rule is a minor speed bump compared to the potential dismantling of banks like behemoth Citigroup that were at the center of the meltdown.

If foes of the Volcker Rule fear the government’s ability to design and implement the rule, they should fear bolder actions even more.



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