What You Should Know about the Volcker Rule

I’m pretty sure you’ve noticed the increased level of volatility in the markets lately as currency pairs have been making larger than usual price swings. For instance, we’ve witnessed EUR/USD rally by more than a couple of hundred pips in a day only to erase all of its gains and more during the next day.

Some market participants attribute this additional dose of volatility to the increased level of trading activity after the December holidays, but others believe that market regulation factors may also be in play. During the FX Invest Europe Conference, some analysts pointed out that the new requirements under the Volcker Rule might have something to do with the wilder price swings we’ve been witnessing recently.

What is this Volcker Rule all about?

The Volcker Rule, which is part of the recently enacted Dodd-Frank legislation, imposes limits on proprietary trading. According to the rule’s proponent and former Federal Reserve chairman, Paul Volcker, this trading activity is partly to blame for the 2008 financial crisis.

To be specific, the Volcker Rule aims to prevent banks from using their own funds to make speculative bets in the markets. This way, the banks’ losses on their trades won’t directly restrict their ability to lend to consumers and businesses.

Sounds good, right? However, you should know that not everyone is in favor of the Volcker Rule.

Most market participants are worried that despite its good intentions, the regulation would also hamper market making; an activity with an entirely different purpose but very similar to proprietary trading.

Basically, a market maker is an entity that both buys and sells assets to facilitate a fair and orderly market for their clients. On the other hand, proprietary traders buy and sell assets to make speculative bets for the company using shareholders’ or creditors’ money.

The SEC (Securities and Exchange Commission) has acknowledged the purpose of market making and cited it as an exemption to the rule. However, because both activities involve buying and selling using a firm’s own account, it becomes very difficult to distinguish it from propriety trading.

Market makers are important because they provide liquidity in the market. But as players become wary of conducting market making transactions to avoid violating the Volcker Rule, there is less liquidity to keep prices from shifting too quickly (i.e., become more volatile). As I said earlier, a few traders are already saying that the recent spike in volatility in the forex market is because a handful of banks were already making the necessary adjustments to comply with the law.

Also, another unintended consequence of the Volcker Rule could be that firms charge higher transaction costs to make up for the lower volume. Yikes!

It is only right to acknowledge the U.S. Congress’ efforts to keep another financial crisis from happening. However, in my humble opinion, policymakers still have a lot of work cut out for them in coming up with rules that will make the economy resistant to financial shocks without choking the markets. Perhaps they should reconsider their plan of implementing the Volcker Rule on July 21, 2012.

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