Report: Make Volcker Rule Market-Specific

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WASHINGTON — Federal regulators should use a data-driven and phased-in approach to the trading restrictions imposed by the Volcker rule and employ different approaches to different financial markets, according to a report issued by the Bipartisan Policy Center Thursday.

The paper is part of an effort by the nonprofit group, founded in 2007 by a bipartisan group of former U.S. senators, to examine the Dodd-Frank Act closely to determine which parts of it are or are not working. The proposed Volcker rule, mandated by Section 619 of Dodd-Frank, would restrict an insured depository institution and its affiliates from engaging in proprietary trading. The idea behind the rule is to stop banks from gambling federally insured money from traditional banking services on the bank’s own behalf in the financial markets.

The proposal includes an exemption for trades of U.S., state, and local government securities, but not subdivisions such as turnpike or sewer authorities. Muni groups and the Municipal Securities Rulemaking Board have warned the rule, which has yet to be finalized despite Section 619 becoming effective last year, could damage municipal markets by creating a liquidity problem.

“Judging the intent of a trade in real-world situations is not an easy task,” states the paper authored by James Cox, Jonathan Macey, and Annette Nazareth. “For example, for the purposes of market-making, a financial institution may buy securities that it reasonably expects its clients will want to purchase. If market conditions change or the institution simply misjudges, those securities may go unsold for longer than expected, which could resemble proprietary trading.”

The paper recommends that regulators shy away from a “one size fits most” approach and use data and approaches most appropriate to each market. The muni market, for example, is illiquid and assets are frequently held for long periods of time without being traded.

“Regulators should identify an appropriate set of metrics holistically in a way that best fits each asset class, product, and market,” the report concluded. “The usefulness of any given metric will vary depending on asset class, liquidity of financial instruments, and other specific market characteristics. For example, a metric that relies on bid-ask spreads is unlikely to be as effective in relatively illiquid markets where trading is infrequent than in more liquid markets.”

The final rule should also be phased in slowly to allow the regulators themselves time to respond to unforeseen effects, the report urges.

Above all, the final rule must be clear.

“It is imperative that the agencies get it right, because the regulations will have a significant impact on a wide variety of stakeholders,” the report says. “A Volcker Rule that lacks clarity could allow activities that Congress intended to be impermissible to continue to take place on one hand, and chill legitimate market-making and hedging activity on the other.”

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