My colleague Ugo Egbunike says that the "innovation and growth" of the ETF market would be hit if the Volcker rule affected banks' ability to make markets in ETFs. Seed capital might go missing, traders might be prevented from getting involved in so-called "create-to-lend" operations, and banks may be prohibited from acting as authorised participants for ETFs altogether, one US firm, Bank of America, argues in its submission to the Commodity Futures Trading Commission.
“The (Volcker) proposal creates significant uncertainty about the future functioning of the ETF market, which could have widespread negative impacts on the financial markets more generally,” says BoA.
What's the point of the Volcker rule? The former Fed chairman's argument is that, since a robust banking network is essential and the largest firms continue to benefit from an implicit taxpayer subsidy, proprietary trading should be heavily reined in. If you want to speculate with your own capital, fine; but not if you want to do it at the public's expense. Market-making activities should be strictly client-focused.
In a comment letter to regulators, quoted by the Financial Times, Volcker points a finger at particular areas of bank activity that require special attention. “Various arbitrage strategies, esoteric derivatives and structured products will need particular attention, and to the extent that firms continue to engage in complex activities at the demand of customers, regulators may need complex tools to monitor them,” he warns.
ETF-related trading clearly falls into the category of bank activities warranting close supervision, not least because it’s particularly difficult to draw the line between true market-making and proprietary trading. Banks’ operations in the repo and securities finance markets are another area of potential concern. Ironically, here the Volcker rule draft currently gives banks an exemption but two of the authors of the legislation are now saying it should be removed, precisely because apparently straightforward secured lending transactions can be used to disguise speculative trades.
In the ETF market, complicated arbitrage operations like create-to-lend, involving high levels of short interest with respect to underlying fund assets, as well as repeated evidence of delayed settlement in the secondary market, all give grounds for concern that apparently “matched” delta-one trades are being used to disguise such speculative positions.
For those who dispute that this is going on, I’d simply point in the direction of last summer’s UBS fraud and argue that the onus is on the banks to prove that they are not involved in prop trading, rather than the other way around. The UBS trader concerned was clearly given leeway to generate profits from position-taking for his desk and bank. Even though he apparently exceeded them through concealment and the exploitation of lax European settlement rules, his employer’s initial inability to spot that things were wrong also hints at a business model that was designed to generate revenues from speculation.
Other circumstantial evidence that a lot more than client order-matching is going on comes from repeated references to the profitability of delta-one trading (of which ETFs are an increasingly large part). I also hear on the grapevine that a large part of the equity division’s trading profits at a major European bank in 2011 came specifically from ETFs.
There’s nothing wrong with making money. But the Volcker rule and the equivalent moves in other countries to rein in banks’ proprietary trading activities are to do with preventing another build-up of risk that results in an enormous margin call on the man in the street who didn’t even know he was gambling. If banks don’t like these constraints, let them cut themselves loose from taxpayer support and speculate to their hearts’ content. In doing this, they’d also be operating on a truly level playing field with all the non-bank ETF market makers who don’t have a taxpayer guarantee.
Resolving the free-rider problem in banking, which Volcker and many others are trying to do, Ugo, is more important than allowing scope for financial creativity or ensuring the future growth of the ETF market.