The Obama Fallout

A week has passed since US President Obama announced his “Volcker Rule” to curb banks’ proprietary trading activities, but a great deal is still tantalisingly unclear.

Was Obama’s announcement the most profound event in American politics in the last fifty years, as I saw hedge fund manager Hugh Hendry claim in a Channel 4 news interview at the end of last week? Or is this destined to be another grand initiative that peters out after aggressive bank lobbying and congressional horse trading, as many jaundiced observers expect?

We’ll have to wait and see. For me, the most difficult challenge facing legislators will be defining what constitutes proprietary trading. Goldman Sachs’s CFO very quickly came out with a figure of 10% as the contribution to the firm’s revenues that such activities represent.

However, it’s hardly a secret that investment banks (and not just Goldman) regularly use what are notionally client trades to establish proprietary trading positions. In other words, if a bank decides it wants to short Russia (for example), it’s a lot easier, safer and more effective to do this by getting clients to go long Russia (i.e., put on the opposite trade) than by going into the market and selling Russian equities directly. Analysts of the firm will paint a bullish story to get outside investors to buy, even when the bank itself is going short.

Actually stopping firms from doing this kind of thing will be hard unless we want to go back to a complete separation of agency and principal trading (such as existed in London before 1986).

But maybe we should just take Obama and Volcker at their word and assume that, as columnist John Kemp of Reuters wrote a few days ago, they will ensure that “if non-core institutions make poor choices they will fail and the losses will fall on shareholders rather than depositors or taxpayers. In the event of a systemic crisis they will also fail unless they keep sufficient liquidity on hand. Higher risk will be reflected in lower ratings and an increased cost of funding, ending the anomaly where institutions in the financial system that take the largest risk have the lowest funding costs.”

No wonder bank stocks have fallen so heavily over the last week. But what are the implications for the European financial markets and for the ETF business in particular?

Although Obama’s jurisdiction doesn’t (formally) extend across the Atlantic, it only took until Tuesday this week for Mervyn King of the Bank of England to propose a similar ban on proprietary trading activities by commercial banks in the UK.

However, in continental Europe, where the idea of universal banking is more deeply entrenched and where credit bubble excesses were not as extreme as in the Anglo-Saxon economies, a similar separation of activities is not yet on the cards, it seems.

Regulation of over-the-counter derivatives markets is a key part of the Obama-Volcker plan, and if this were to extend to Europe then a major rethink of European ETF structures might be necessary, since a great number of funds depend on OTC swaps to provide their returns. This, however, would in turn require changes in the European UCITS fund rules, which specifically authorise synthetic trackers, based on derivatives.

It seems obvious that smaller, independent market-making firms, many of whom are already actively involved in the exchange-traded fund business, might be expected to increase their market share at the expense of the larger banks’ trading desks. But capital to back trading may become scarcer – and liquidity could suffer as well, not least as a result of the proliferation of ETF listings in Europe.

Some ownership structures in the ETF market might also have to change. Principal investments have been a big part of some banks’ activities in the last decade, including ventures like trading platform Turquoise, data and index specialist Markit and ETF provider Source, all of which had investment bank seed capital. Regulation might lead to entities like these having to find completely separate backers.

These are stabs in the dark at what might follow from what some have called “Glass Steagall III” (versions one and two having been enacted in 1932 and 1933). It will probably be weeks or months before the legal framework becomes clearer.

But there will be plenty to discuss for the expert panellists we are assembling for our inaugural European ETF conference in Amsterdam in April. Regulation and the European trading infrastructure will be key themes. I hope to see as many of you there as possible!

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