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
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 Liquidity that is propped up by banks for speculative reasons is apt to be withdrawn abruptly, when marketconditions become disfavorable.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.”
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.
OTC markets typically feature inordinate levelsof leverage that lead to non-Pareto optimal levels of default risk.
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.”
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.
Liquidity Black Holes: What are they and how are they Generated
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.”).
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.
. at n. 104.