I HAD A couple of discussions this past week on two completely different tracks with different people but which shared a distinct affinity. The first was with a market professional in town from Nigeria. We got to talking about the outcome of the elections and he told me: “There’s a big difference in Nigeria between winning an election and being sworn in.” Welcome to the emerging markets!
A couple of days later I was chatting with a senior global markets guy at a big European bank about, among other things, the impact of banking regulation and he said: “There’s a big difference between what regulators say they’re going to go and what they ultimately end up doing.” Particularly, I guess, in the European Union, where the labyrinthine road to ratification is long, convoluted and fraught.
If you’ll forgive my slightly meandering intro, I was just thinking about the latter point in particular when I saw Latvia, which currently holds the EU presidency, fronting a dialogue about reversing the ban proposed by the European Commission on proprietary trading. The reversal has, of course, been in the ether ever since the EC published its hard-line proposal for a regulation in January 2014. That proposal had come out of the Liikanen report, presented back in October 2012, as well as member states’ domestic rules and Financial Stability Board work on the subject.
In essence, the proposal said that prop trading in financial instruments and commodities by the “largest and most complex EU banks with significant trading activities” would be banned. But it also afforded supervisors the power to transfer high-risk trading activities to separately capitalised legal entities within the group – this is now the focus of the new thinking, partially driven by poor support for the EC proposal. Incredibly, the EC had included market-making alongside complex derivatives and securitisation as a high-risk activity.
Transfer or separation were not intended to be automatic: the proposal assumed banks would undertake rigorous reporting to enable supervisors to focus on the extent of excessive risk (however defined) ahead of any decision. Banks able to show that their risks were mitigated could avoid such a fate. But the EC proposal was a convoluted attempt to solve an issue whose costs could easily have outweighed its benefits.
I’VE NEVER REALLY understood the vigour with which policymakers in the US and Europe have pushed the prop trading ban by banks. Notwithstanding the fact that it did throw up areas of potential conflict, highlight how fuzzy the lines were at certain shops between fiduciary and non-fiduciary businesses and between market-making and true prop, and draw attention to how banks dealt with internal conflict resolution, it just never made sense in isolation. It was as much a matter of improving internal governance.
The prop trading ship has long sailed in the US, where Dodd-Frank has put paid to the practice. But with the regulatory process in the EU lagging behind, the extreme anxiety that policymakers in Europe now openly exhibit towards the destruction of liquidity in government and corporate bond markets that they’ve caused themselves through imperious, over-bearing and misguided over-regulation is calling loudly for a different approach.
Creating the conditions for growth is at the top of the political agenda, and the European Central Bank and several governments now recognise that the capital and risk intermediation and distribution functions that banks provide have to be a crucial plank of any growth plan. The thinking on trading has clearly been overtaken by the laws of unintended consequences. The focus now is on improving the liquidity and price-discovery process that users of capital markets provide and which the markets themselves need to survive.
The market-making function is frankly dead and buried under the weight of current capital and other rules
IT’S DEEPLY IRONIC that at the same time as regulation is destroying one of the fundamental tenets of a functioning capital market, the same people are pushing ahead with Capital Markets Union to reverse reliance on bank lending in Europe in favour of a process of … ahem … capital marketisation.
Here’s the thing. A reversal of proprietary trading won’t necessarily do anything to improve the market-making function, which is frankly dead and buried under the weight of current capital and other rules. That should be the focus of policymakers’ endeavours.
My fear is that policymakers and regulators confuse proprietary trading with market-making. I’m not going get into the definitional question here that has dogged this debate so far. If you ask 10 people to define proprietary trading they will give you 10 different answers or at least 10 different emphases or nuances. But my point is: market-making is not prop. They exist for different reasons.
If lawmakers think that the shadow banking sector and bank prop desks will fill the gap left by the client-focused trading function and the market-making desk, they will be grievously disappointed. Let’s be clear: hedge funds, other shadow banking entities and prop traders may well offer liquidity to the market but only when it suits them to do so.
At the first sign of trouble, distress or just because there’s nothing in it for them, they’ll withdraw that liquidity completely or, during times of stress, post take-it-or-leave-it Kamikaze death-spiral prices that can create dangerously gapped and dysfunctional markets. The destruction of market-making as we knew it has removed a crucial buffer that facilitated the smooth functioning of Europe’s capital markets. That should form a focal point for direct action.
