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The Volcker Rule Restrictions on Proprietary Trading

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28 March 2012

Implications for Market Liquidity

Abstract

REPORT PREVIOUSLY PUBLISHED BY OLIVER WYMAN

Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (commonly known as the Volcker Rule) was introduced into law in July 2010. The Volcker Rule was proposed as a means of ensuring the safety and soundness of the US financial system by restricting proprietary trading by US banking entities. The five regulatory agencies charged with implementing the statute have now released formal notices of proposed rulemaking that contain draft regulations implementing the Volcker Rule.

The central challenge presented by the Volcker Rule is differentiating prohibited proprietary trading from permitted activity related to market making. In Oliver Wyman's study, The Volcker Rule Restrictions on Proprietary Trading: Implications for Market Liquidity, we focus on one major aspect of this challenge--exploring the risk the proposed rule could pose to market liquidity by establishing a regulatory regime that directly or indirectly constrains dealers’ ability to make markets for their customers.

Oliver Wyman finds that the proposed rule represents a significant risk to market liquidity. We use the US corporate bond market as a case study to simulate the possible effects of an overly restrictive Volcker Rule regime, finding that a plausible reduction in dealers' ability to serve their customers would result in large costs to investors, issuers, and the economy as a whole. We then extend our discussion to parallel risks facing other asset classes and make a set of recommendations to guide policymakers in navigating the critical implementation period to come.

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