The financial crisis of 2008 continues to have a profound effect on the financial markets. This isn’t because of what happened, it’s due to the variety of financial market regulations being put into place to prevent 2008 from ever happening again. Markets, minus housing, have rebounded significantly since the volatile days of 2007-2008. However, this unique era put such a fear into lawmakers that they have responded in the only way they know how, more rules and regulations! Some of these rules and regulations make perfect sense, others seem to be designed to appease special interests without thought to the overall financial impact. Whatever your view of the massive changes taking place, one thing is for certain, Traders are going to need to adapt to a new environment. Let’s take a closer look at some specific changes.
The overall regulation package is called the Dodd-Frank Act. A sub section of the Dodd – Frank Act, that affects traders, is the Volcker Rule. Named after the former Fed chief, Paul Volcker, this rule is designed to prevent a future financial crisis by separating proprietary trading, private equity, and investment banking within banking institutions. What this means, effectively, is that banks will no longer be allowed to trade for their own accounts. While well meaning, the folks who drafted this legislation failed to consider the obvious downside. The rule places strict limits on prop trading and market making. These activities are huge profit centers for banks. Take them away, and you can guess what may happen. The rule does include an exception for market making, but it’s very difficult to determine the difference between market making and prop trading. There are seven standards that need to be met for trading to be considered market making. The main two rules are market makers cannot generally enter orders on their own behalf, it must be for a customer, and cannot hold a security for an extended period of time. In other words, banks can no longer profit very much from market making/trading.
Some of you may be saying… “I don’t work for a bank, why does this matter to me?” Well, for several reasons, primarily the reduction in liquidity that will result once the banks stop trading. This is a huge issue for the market that the rule’s drafters failed to address. In addition, trading costs will likely increase also in response to the rule. These are things the market certainly does not need right now.
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