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Occupy the SEC Letter to House Committee on Financial Services, Re: “Examining the Impact of the Volcker Rule on Markets, Businesses, Investors and Job Creation”

Occupy the SEC Letter to House Committee on Financial Services, Re: “Examining the Impact of the Volcker Rule on Markets, Businesses, Investors and Job Creation”

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Published by occupytheSEC
Occupy the SEC submitted this letter via fax for consideration by the House Committee on Financial
Services (“Committee”), in connection with its investigation of the economic impact of the
Volcker Rule.
Occupy the SEC submitted this letter via fax for consideration by the House Committee on Financial
Services (“Committee”), in connection with its investigation of the economic impact of the
Volcker Rule.

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categoriesBusiness/Law, Finance
Published by: occupytheSEC on Feb 13, 2012
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Occupy the SEC
http://www.occupythesec.orgJanuary 17, 2012House Committee on Financial Services2129 Rayburn House Office BuildingWashington, DC 20515
Re: “Examining the Impact of the Volcker Rule on Markets, Businesses,Investors and Job Creation”
 
Dear Sirs and Madam:Occupy the SEC
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submits this letter 
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for consideration by the House Committee on FinancialServices (“Committee”), in connection with its investigation of the economic impact of theVolcker Rule.The Committee has received extensive input from commentators proclaiming that the Volcker Rule will harm the financial markets and suffocate market “liquidity.” These commentatorssuffer from what Keynes referred to as the “fetish of liquidity,” that most “anti-social maxim of orthodox finance.”
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Instead of considering the Volcker Rule's impact on levels of employment,output or growth in all markets, such commentators primarily focus their analysis on the potential impacts of the Rule on banks. In doing so, they gloss over the numerous benefits to bereaped from vigorous implementation of the Volcker Rule.
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Occupy the SEC (http://occupythesec.org) is a group within the New York-based Occupy Wall Street(“OWS”) protest movement. We are a group of concerned citizens, activists, and financial professionals withdecades of collective experience working at many of the largest financial firms in the industry. Together, we makeup a vast array of specialists, including traders, quantitative analysts, compliance officers, technology and risk analysts. We hope that our technical expertise provides a clear voice advocating for the American public amidst thecacophony of spin emanating from the powerful financial services lobby.
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This letter represents the opinion of our group’s members, and does not represent the viewpoints of OWSas a whole.
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John Maynard Keynes,
The General Theory of Employment, Interest and Money
155 (1936).
 
 
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A. Benefits for Depositors and Investors
Many of the Volcker Rule’s liquidity costs occur in the form a zero-sum game, wherein a banking entity’s “cost” serves as a benefit to depositors and the public in general. While theVolcker Rule may reduce banking profits resulting from proprietary trading, such lost profits arenot unanticipated “costs,” but rather benefits that form the crux of Dodd-Frank Section 619'sintended regulatory effect.Proprietary trading by a government-backstopped bank involves the distinct possibility of the bank needing to be bailed out, whether through depositors' funds, Federal Reserve financing,or taxpayer subsidies. The costs associated with these forms of bailout must be included in theequation when considering the economic impact of the Volcker Rule. Thus, to the extent that banks face costs from their compliance obligations or from lost proprietary trading profits,depositors and the public are concomitantly saved the externality costs of potential bailouts.Strict enforcement of the Volcker Rule’s ban on “proprietary trading” by banking entitieswould reduce the risk of bank failure, as only the most basic, customer-focused trades couldmake it through the Rule’s gauntlet. This outcome would increase both depositor and investor confidence in banking entities, which in turn would increase real liquidity in the bankingindustry, and as a consequence, the overall market for credit. Increases in real liquidity woulddrive down real interest rates, improve consumption and help the global economy rebound fromits currently depressed state.
B. Impact on Artificial Liquidity
Commentators have extensively discusses the possibility that the Volcker Rule’srestrictions on proprietary trading will cause reduced liquidity and expanded credit spreads,especially in currently illiquid markets.First and foremost, the Congressional intent behind Section 619 was to re-orient bankstowards stable, customer-focused activities. This necessarily involves a shift away from tradingin risky, illiquid markets. It should be noted that the Volcker Rule does not prohibit proprietarytrading by all entities. Rather, it focuses solely on government-backstopped banks that haveaccess to easy money through the Federal Reserve and customer deposits. Thus, even if “banking entities” are precluded from making illiquid markets, those markets can continue to beunderwritten by conventional investment banks. Thus, any supposed impact on overall liquidityor credit spreads is questionable.Moreover, much of the so-called “liquidity” that the banks have engineered, especially inopaque OTC markets, can be most appropriately termed “artificial liquidity.” As onecommentator notes, the “very belief that the proliferation of financial derivatives andsecuritization techniques has enhanced global liquidity has been [the] core illusion driving thesub-prime bubble in the USA.”
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Anastasia Nesvetailova,
Three Facets of Liquidity Illusion: Financial Innovation and the Credit Crunch
, 4German Policy Studies 83, 94 (2008).
 
 
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Proprietary trading involves buying and selling purely for speculative reasons that havelittle to do with a true assessment of a financial position’s underlying value. This createsinefficiencies in the market price of such positions. True price discovery is impeded by thehyper-liquidity that is introduced by speculative prop traders. This hyper-liquidity, motivated bynothing more than expectations of short-term price movements, creates inefficient subsidies to buyers and sellers in the market. Depositors and the Federal Reserve unwittingly pay for thesesubsidies by funding banks’ trading activities.The Committee should recognize the fact that certain markets
 should 
feature large creditspreads, simply because they involve truly risky products. Market-makers in illiquid marketsoften impede natural market forces by engaging in self-interested, rent-seeking trades that createartificially narrow spreads. Thus, a reduction in prop trading may have the effect of increasingspreads, but that is actually a systemic benefit, not a cost, because those wider spreads will moreaccurately reflect the risk involved in those positions. Free of the market obfuscation created by proprietary traders, investors would be able to more efficiently allocate capital.Hyper-liquidity may even paradoxically exacerbate market volatility. Liquidity that is propped up by banks for speculative reasons is apt to be withdrawn abruptly, when marketconditions become disfavorable. This creates “liquidity blackholes,” which are “episodes inwhich the liquidity faced by a buyer or seller of a financial instrument virtually vanishes,reappearing again a few days or weeks later.”
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This disappearance and re-appearance of capitalcreates market volatility, which is anathema to investors and depositors alike. A stable marketwith moderate credit spreads would be a more salutary alternative to this scenario.Even if illiquid markets were somehow debilitated by the Volcker Rule, there wouldlikely be minimal impact on overall market efficiency and capital formation. If banks areconstrained in their ability to conduct legitimate market-making, this will create market pressurefor financial instruments to move to established exchanges and ECNs, which empirical studiesdemonstrate to be relatively efficient and safe.
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OTC markets typically feature inordinate levelsof leverage that lead to non-Pareto optimal levels of default risk.
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Indeed, as one commentator noted, “[i]t is surprising that banking authorities have not [explicitly] required banks to move []derivatives market-making activity to a centralized exchange where transparency is enhancedand bank exposure to counterparty default risk is greatly reduced.”
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A reduction in the size of adealer-made market would siphon investments into efficient, transparent and less-riskyalternatives. The primary utility of illiquid instruments instruments seems to be in generatinglucrative fees for originators and market-makers. The more “exotic” the instrument, the higher the potential for compensation for no reason other than that instrument’s opacity.
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Avinash Persaud,
 Liquidity Black Holes: What are they and how are they Generated 
(Apr. 2003),http://www.g24.org/Workshops/pers0403.pdf.
 
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See
Ronald W. Masulis & Randall S. Thomas,
 Does Private Equity Create Wealth? The Effects of Private Equity and Derivatives on Corporate Governance
, 76 U. Chi. L. Rev. 219 (2009) (“many large [financialinstitutions] act like markets in over-the-counter interest rate, currency and credit default swaps, and other morecomplex derivatives, being long and short similar contracts. This large degree of derivative exposure by [financialinstitutions] raises some serious questions and makes it all the more important to have strong board oversight of [their] derivative risk exposure.”).
 
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Viral Acharya & Alberto Bisin, Centralized versus Over-The-Counter Markets, Mar. 16, 2010,http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/acharya_bisin_otc.pdf.
 
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 Id 
. at n. 104.
 

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