Darrell Duffie - Stanford University

8/3/2019 Darrell Duffie - Stanford University

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MarketMakingUndertheProposedVolckerRuleDarrellDuffie

StanfordUniversityJanuary16,2012

AbstractThissubmissiondiscussesimplicationsforthequalityandsafetyoffinancialmarketsofproposedrules

implementingthemarket-makingprovisionsofsection13oftheBankHoldingCompanyAct,commonlyknownastheVolckerRule. Theproposedrules1 havebeendescribedbytheOfficeoftheComptrollerof theCurrency, theBoardofGovernorsoftheFederalReserveSystem, theFederalDepositInsuranceCorporation,andtheSecuritiesandExchangeCommission. TheAgenciesproposed implementationoftheVolckerRulewouldreducethequalityandcapacityofmarketmakingservicesthatbanksprovidetoU.S.investors. Investorsandissuersofsecuritieswouldfinditmorecostlytoborrow,raisecapital,invest,hedgerisks,andobtain liquidity fortheirexistingpositions. Eventually,non-bankprovidersofmarket-making services would fill some or all of the lost market making capacity, but with an unpredictableand potentially adverse impact on the safety and soundness of the financial system. These near-termandlonger-runimpactsshouldbeconsideredcarefullyintheAgenciescost-benefitanalysisoftheirfinalproposedrule. Regulatorycapitalandliquidityrequirementsformarketmakingareamorecosteffectivemethodoftreatingtheassociatedsystemicrisks.

DeanWitterDistinguishedProfessor ofFinance,Graduate School ofBusiness, StanfordUniversity. This submission isalso a report requested from the author by SIFMA.Rather than compensating the author, SIFMAwillmake a charitablecontribution of $50,000 to the The Michael J. Fox Foundation for Parkinsons Research. For other potential conflicts ofinterest,seewww.stanford.edu/duffie/ Iampleasedtoacknowledgecomments fromViralAcharya,YakovAmihud,MarkusBrunnermeier,VincentdeMartel,PeterDeMarzo,PeterFisher,MichaelFleming,AndrewLo,GeneLudwig,JeffMeli,AndrewMetrick,LasseHejePedersen,JacquesRolfo,GabrielRosenberg,JeremyStein,JohnTaylor,andHaoxiangZhu.Theopinionsexpressedhereareentirelymyown,anddonotnecessarilyreflecttheviewsofanyoneelse.

1SeePROHIBITIONSANDRESTRICTIONSONPROPRIETARYTRADINGANDCERTAIN INTERESTS IN,ANDRELATIONSHIPSWITH,HEDGEFUNDSANDPRIVATEEQUITYFUNDS,authoredbyOfficeoftheComptrolleroftheCurrency,Treasury (OCC);BoardofGovernorsof theFederalReserveSystem (Board);FederalDeposit InsuranceCorporation (FDIC);andSecuritiesandExchangeCommission (SEC).Reference: BOARDOFGOVERNORSOFTHEFEDERALRESERVESYSTEM12CFRPart248,DocketNo.R-1432,RIN:7100AD82.Fromthisproposaldocument,IfocusprimarilyonQuestions80,81,82,83,84,87,89,92,93,96,and97posedbytheAgencies.

1
http://www.stanford.edu/%1Aduffiehttp://www.stanford.edu/%1Aduffiehttp://www.stanford.edu/%1Aduffiehttp://www.stanford.edu/%1Aduffie


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1 ExecutiveSummaryInasectionoftheDodd-FrankActcommonlyknownastheVolckerRule,Congressbannedproprietarytradingbybanksandtheiraffiliates,butexemptedproprietarytradingthat isrelated tomarketmaking, among other exemptions. Proprietary trading is the purchaseand saleoffinancial instrumentswith the intent toprofit from thedifferencebetween thepurchasepriceandthesaleprice.Marketmaking isproprietarytradingthatisdesignedtoprovideimmediacy to investors. Forexample,an investoranxious to sellanasset reliesonamarketmakers standingability tobuy theasset for itself, immediately. Likewise, ainvestorwhowishes tobuyanassetoftencallsonamarketmaker to sell theassetoutofitsinventory.Marketmakershandlethemajorityoftradingingovernment,municipal,andcorporate bonds; over-the-counter derivatives; currencies; commodities; mortgage-relatedsecurities; currencies; and largeblocksof equities. (TheVolckerRule exempts currencies,United

States

treasuries,

federal

agency

bonds,

as

well

as

certain

types

of

state

and

municipal

bonds.)Mostmarketmaking,bothintheU.S.andabroad, isconductedbybank-affiliatedbroker-dealers.Several federalagenciesarenowwritingthespecificrulesbywhichtheywill implement

theVolckerRule,which comes into force in July, 2012. In particular, these agencies arechargedwithdesigning rules that implement the exemption formarketmaking. Ibelievethe restrictionsonmarketmakingbybanks intheirproposed ruleswouldhavetwomajorunintendedconsequences:1.Over the years duringwhich the financial industry adjusts to theVolckerRule, investorswould experiencehighermarket execution costs anddelays. Priceswouldbemorevolatile in the faceof supplyanddemand shocks. This lossofmarket liquiditywouldalsoentailalossofpricediscoveryandhighercostsoffinancingforhomeowners,municipalities,andbusinesses.

2.Thefinancialindustrywouldeventuallyadjustthroughasignificantmigrationofmarketmakingtotheoutsideoftheregulatedbanksector.Thiswouldhaveunpredictableandpotentiallyimportantadverseconsequencesforfinancialstability.

Iwill

elaborate

on

these

consequences

and

suggest

an

alternative

approach,

of

using

capital and liquidity requirements to conservatively buffermarket-making risks. Marketmakingrisks,andotherriskstakenbyabank,areunsafewhenevertheyare largerelativetothecapitalandliquidityofthebank.

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2 SummaryThisreportdiscussesimplicationsforthequalityandsafetyoffinancialmarketsofproposedrules formarketmaking by banks under section 13 of theBankHoldingCompanyAct,the VolckerRule. These rules have been proposed by theOffice of theComptroller oftheCurrency, theBoardofGovernorsof theFederalReserveSystem, theFederalDepositInsuranceCorporation,andtheSecuritiesandExchangeCommission(theAgencies).TheAgenciesproposedimplementationoftheVolckerRulewouldreducethequalityandcapacityofmarketmakingservicesthatbanksprovidetoinvestors. Investorsandissuersofsecuritieswouldfind itmorecostlytoborrow, raisecapital, invest,hedgerisks,andobtain liquidityfortheirexistingpositions.Eventually,non-bankprovidersofmarket-makingserviceswouldfillsomeoftheresultingvoidinmarketmakingcapacity,butwithanunpredictableimpacton the safety and soundness offinancialmarkets. I believe thesenear-term and long-runimpacts

should

be

considered

carefully

in

the

Agencies

cost-benefit

analysis

and

final

rule

making.Perhapsinlightofthesepotentialadverseconsequences,Congressexemptedproprietary

tradingrelatedtomarketmakingandcertainotherclient-orientedservicesfrom itsproprietarytradingrestrictionsonbanks.TheAgenciesstatethattheyhavethereforeendeavoredtodevelopaproposedrule thatdoesnotundulyconstrainbankingentities in theireffortsto safely provide such services. Inmy opinion, the proposed implementing ruleswouldnot succeed in this respect. I suggest instead rigorous capital and liquidity requirementsformarketmakers, combinedwith effective supervisorymonitoring,with the objective ofensuringthatbankshaveabundantcapitalandliquiditytocovertheirmarket-makingrisks.TheAgenciesproposedimplementationoftheVolckerRuleseemstobewrittenfromthe

viewpointthatatrade involvingsignificantriskofgainor loss,ortakenwiththeobjectiveofprofitingfromexpectedchangesinmarketprices,isnotconsistentwithbonafidemarketmaking.Thisisnotthecase.Marketmakingisinherentlyaformofproprietarytrading.Amarketmakeracquiresaposition fromaclientatonepriceand then laysoff thepositionover timeatanuncertainaverageprice. Thegoal is tobuy low, sellhigh. Inorder toaccomplish thisgoalonaverageovermany trades,withanacceptable levelof risk for theexpectedprofit,amarketmakerreliesonitsexpectationofthefuturepathofmarketprices.Future prices are uncertain because of unforeseen changes in economic fundamentals andmarket conditions. The length of time overwhich a positionmust be held is subject totheunpredictable timinganddirectionofclientdemands for immediacy. These risksvarysignificantly across time because of changes inmarket volatility and significant variationin the sizes of positions thatmarketmaking clientsmaywish to acquire or liquidate. Amarketmaker isalso sometimes exposed to investors thatarebetter informed than itself.

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Thegreatertheextenttowhichtheproposedrule issuccessfulatreducingmarketmakingrisk, themore itwill reduce the effective amount ofmarketmaking services provided toclients. Thiswouldnotbenefit ourfinancial system, relative to the alternative of capitalrequirementsthatforceamarketmakertosafelyabsorbitsownlosses.In

order

to

provide

significant

immediacy

to

its

customers,

amarket

maker

requires

sub

stantialdiscretionandincentivesregardingthepricing,sizing,andtimingoftrades. Itmustalsohavewide latitudeand incentives for initiating trades, rather thanmerelyreacting tocustomerrequestsforquotes,inordertoproperlyriskmanageitspositionsortoprepareforanticipatedcustomerdemandorsupply.Likewise,inordertoefficientlyprovideliquiditytoitsclients,amarketmaker reliesheavilyon theoption tobuyand sell fromothermarketmakers.While theAgencies accurately describe the relevance of these forms ofmarket-making

discretion andmake some allowance for them, the criteria andmetrics that are proposedwould nevertheless substantially discourage the use ofmarketmaking discretion. Bankswouldfrequentlyfindthatmeetingaclientsdemandsforimmediacywouldbeunattractivelyriskyrelativetotheexpectedprofit. Inparticular,abankthatcontinuestooffersubstantialmarketmaking capacity to its clients would face a risk of regulatory sanction (and theattendantstigma)duetosignificantandunpredictabletimevariationintheproposedmetricsforriskandforprofitassociatedwithchangesinmarketprices.Likewise,thenormsthatarelikelytoarisefromtheproposedregulatorymetricswoulddiscouragediscretionbyindividualmarketmaking traders inthe faceofcareerconcerns. A traders incentivesanddiscretionwouldalsobedampenedbytheproposedapproachtocompensation.Consequently,somebanksmaywishtoexitthemarketmakingbusiness. Alternatively,

under the proposed rule, a bank could significantly reduce the amount of capital that itdevotestomarketmaking,merelyofferingthisservicewithinmodestrisklimitsinordertocream-skimtheeasiestmarket-makingopportunities.Havingmodestrisklimitsisinconsistentwiththeabilitytoprovidesubstantialimmediacytoclients.The resulting increase in investors execution costs and loss ofmarket liquiditywould

alsocauseissuersofsecuritiestobeharmedbylowerprices.ThefactthattheVolckerRuleexemptsU.S.governmentsecuritiesisarecognitionbyCongressthatitwouldharmtheU.S.governmentasanissuerifitweretoapplytheRuletoitsowndebtissues.TheBankofJapanandJapaneseFinancialServicesAgencyhavewritten2 totheAgenciesabouttheirconcernthat the proposedRestrictionswould have an adverse impact on JapaneseGovernmentBonds(JGBs)trading.Theywouldraisetheoperationalandtransactionalcostsoftrading

2See the letter ofMasamichiKono, ViceCommissioner for InternationalAffairsFinancial ServicesAgency,Governmentof Japan, andKenzoYamamoto, ExecutiveDirectorBank of Japan, datedDecember 28, 2011. TheCanadian governmenthaswrittentotheAgencieswitharelatedconcernabout the impactoftheproposed restrictionsonthe liquidityofnon-U.S.government bonds. See the letter of JulieDickson, Superintendant,Office of the Superintendant ofFinancial Institutions,GovernmentofCanada,December28,2011.

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inJGBsandcouldleadtotheexitfromTokyoofJapanesesubsidiariesofUSbanks. SomeoftheJapanesebanksmightbeforcedtoceaseordramaticallyreducetheirUSoperations.Thosereactionscould furtheradverselyaffect liquidityandpricingoftheJGBs. Wecouldalsoseethesamepictureinsovereignbondmarketsworldwideatthiscriticaljuncture.Wewould

appreciate

your

expanding

the

range

of

exempted

securities

substantially,

to

include

JGBs.TheAgenciesproposedrestrictionswouldlikewiseadverselyaffectU.S.corporationsandhomebuyerswho, liketheUnitedStatesand foreigngovernments,benefit from liquidcapitalmarketsthrough lower interestexpense. If investorsanticipateasecondarymarketwith higher execution costs and delays due to a lack ofmarketmaking capacity, alongwithhigherpricevolatility, then theywilldemandhigherbondyieldsonnew issues. ThemarketsforU.S.corporatebondsandnon-agencymortgage-relatedsecuritiesareparticularlyimportantexamplesofmarketsthatwouldbeharmedbytheproposedrule. Corporationswould likewise faceahighercostofcapitaldue to lower liquidity in the secondarymarketfortheircommonshares.Although treasury, agency, and some types ofmunicipaldebt securities are exempted,

theproposed rulewould reduce the liquidityofmarkets for interest rate swapsandotherderivativesusedtohedgethesesecurities.Thus,therulecouldsomewhatelevategovernmentborrowingcosts.The proposed rulewould also hamper efficient price discovery, lowering the quality of

informationabout economic fundamentals that is revealedbymarkets. For example,during thefinancial crisis of 2007-2009, the reducedmarketmaking capacityofmajordealerbankscausedby their insufficient capital levels resulted indramaticdownwarddistortionsincorporatebondprices.In the long term, the proposed disincentives formarketmaking byU.S. bankswould

probably leadtoasignificantmigrationofmarketmakingand investmentactivities. SomeoftheseactivitiescouldmoveoutsideoftheUnitedStates. WithintheU.S.,theproposedrulecouldspurtheemergenceoflargenon-bankbrokerdealers.Forexample,theproposedrulemayleadsomecurrentbankswhosebusinessmodelsdependheavilyonmarketmakingto give up theirbanking charters. Given the difficulty of competingwhen subject to theproposed market making rules, other large banks could choose to spin off their marketmakingbusinesses.Someofthelostmarket-makingcapacitymightbefilledbyexistingnon-bankfirmssuch

as hedge funds or insurance companies. Insurance firmsmight not, under the proposedrule,besignificantlyconstrainedintheireffectivemarket-makingactivities. Insurancefirmsfallunderasystemofregulatorytransparency,capital,and liquidityrequirementswhich isnotdesigned to treatmarketmaking risk. Hedge fundshave extremely limited regulatoryoversight. Somemarketmaking couldbe replacedbyanew formofbrokerage conducted

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by largeasset-managementfirms. For example, an investorwhowishes to enteror exitaposition couldnotify theassociated tradingdeskofa largeasset-managementfirm. Byapriorcontractualarrangementwiththeclientsof theasset-managementfirm, that tradingdeskcouldhavebeengiventhediscretiontotemporarilyadjusttheclientsportfolioswithinspecified

asset-allocation

bands

so

as

to

accommodate

the

desired

trade.

Theseoutcomesseeminconsistentwithcongressionalintent,andhaveunpredictableand

potentiallyadverseconsequencesforthesafetyandsoundnessofourfinancialsystem.Leadingup to thefinancialcrisisof2007-2009, theUnitedStateswasunique inhaving severaloftheworlds largestbroker-dealersoutsideof itsregulatedbankingsector. The failureofsomeof theseandnear failureofothersdramaticallyexacerbated thatcrisis. By spurringa somewhatunpredictable transition tonon-bankdealers, theproposed rule could reducefinancial stability. Thisconcern isreduced somewhatby theprospect that largenon-bankdealerswill be designated as systemically important by theFinancial StabilityOversightCouncil.Accesstotheliquiditysupportofthecentralbank,however, ismorecumbersometoarrangefornon-banks,especiallygiventheDodd-FrankprohibitionofemergencyliquidityprovisionbytheFederalReserve to individualnon-banks. Further,Basel III liquidityandcapitalrequirementsdonotapplytonon-bankbrokerdealers.Thus,itisprematureatbesttoassumethatnon-bankmarketmakerswillhaveregulatory

supervision,accessto liquidity,andcapitaland liquidityrequirementsthatareaseffectiveasthoseforregulatedbanks.Thefailureorsuddenlossofcapacityofa largebrokerdealerisat leastasadversefortheeconomyasthefailureofasimilarly largefinancialinstitutiondevotedtoconventional lendinganddeposittaking. Ibelievethecostsandbenefitsofthepotentialmigrationofmarketmakingservicestonon-banksshouldbecarefullyconsideredbytheAgenciesbeforetheirrulesarefinalized.The proposed rule would directly discourage the discretion ofmarketmakers to effi

ciently absorb significant risks from their clients through theprovision of immediacy. Asaconsequence,therulewouldalsoreducetheallocationofcapitaltomarketmakingbusinesses. Thesedirectand indirect effectswould increase trading costs for investors, reducetheresiliencyofmarkets,reducethequalityofinformationrevealedthroughsecurityprices,and increasethe interestexpenseandcapital-raisingcostsofcorporations, individuals,andothers. These outcomeswould lead to somewhat lower expected economic growth. Themigrationofasignificantamountofmarketmakingoutsideoftheregulatedbankingsectorwasnot intendedbyCongress,wouldbe likelyunder theproposedrule,andhaspotentialadverseconsequencesforsystemicrisk.This report isnotacomprehensiveanalysisoftheproposed rule. Rather,myobjective

istofocusonsomekeyprinciples. Idonotproposealternativemetricsfordetectingriskymarketmaking.Althoughsomeformsoftradingthatclearlyservenomarketmakingintent

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3

canbeproscribed,anattempttoseparatelegitimateandacceptablemarketmakingfromspeculative and riskymarketmaking is not productive, inmy opinion. The objectiveshouldbetoensurethatmarketmakersclearlyhaveabundantcapitalandliquiditytocovertheriskstheytake.The

next

section

of

this

report

describes

how

and

why

market

makers

provide

immedi

acy,and illustratestheadversepricedistortionsthatcanbecausedbya limitedsupplyofimmediacy. Inthefollowingsection,Idiscusstheimpactoftheproposedrulesontheabilityorincentivesofmarketmakerstoprovideimmediacy,andthelikelynegativeconsequences.Finally,afteraconcludingsection,Iraiseandrespondtosomequestionsthatmayberaisedbythisreport.

TheProvisionof ImmediacybyMarketMakersAsopposedtoabroker,whomerelymatchesbuyersandsellers,amarketmakeritselfbuysand sells assets, placing its own capital at risk. The service that it provides is immediacy,theabilitytoimmediatelyabsorbaclientsdemandorsupplyofanassetintoitsowninventory. At any given point in time, the set of other investorswhowould in principlebe prepared to bid competitively for the clients trade is not generally known or directlyaccessibletotheclient.Theclientcouldconductanauctionorasearchforanothersuitablecounterparty,butthistakestime.Evenifinterestedcounterpartiescouldbequicklyidentified,theywouldnotnecessarilyhavetheinfrastructureorbalance-sheetcapacityrequiredtoquickly

take

the

clients

trade.

The

client

is

therefore

often

willing

to

offer

aprice

concession

toamarketmakerinordertotradeimmediatelyratherthansufferadelaythatexposestheclienttopricerisk. Iftheclientwishestoliquidateapositionforcash,itmayalsohaveanopportunitycostfordelayedaccesstothecash.3Iftheasset istradedonanexchange,theclientcouldobtainsomedegreeof immediacy

from the exchange limit-order book, butwith an adverse price impact that is increasingin the clients tradeamount. Amarketmaker canoftenhandle largeblock tradeswithlowerpriceimpactthananexchange.Thevastmajorityoftransactionsinover-the-counter(OTC)marketsarewithamarketmaker. TheOTCmarketcoversessentiallyall trade inbonds(corporate,municipal,U.S.government,andforeignsovereignbonds),loans,mortgagerelatedsecurities,currencies,andcommodities,andabout60%oftheoutstandingnotionalamountofderivatives.Whenamarketmakerservesaclientsdemandfor immediacyits inventoryoftenmoves

away from a desired target level. If the inventory is abnormallyhigh or low, themarket3Fora supportingtheoreticalmodel, seeDuffie,Garleanu,andPedersen (2005). Aclientmayalso seek immediacy froma

marketmaker inordertoavoidabroaderreleaseof informationabout itspositionsortrading intentions,whichcouldharm itsaverageexecutionprice.

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Trading day

Inventory

(in

standard

deviations)

0 50 100 150 200 250

2

0

2

4

Figure 1: A plot of the inventory of theU.S.-dollar position of a blockmarketmaking desk of amajorbroker-dealerforasingleequity,AppleInc.,includingeffectivepositionsimpliedbyderivatives(onadeltaequivalentbasis)andothereffectiveexposures.Theinventorylevelsareshownafterscalingbythesamplestandarddeviationof thedollar inventory levels for the sampleperiod, a contiguousperiodof2010-2011.Source: SIFMA-memberdata.

maker typically shifts its bid and ask quoteswith the goal ofmoving its inventory backtoward itstargetovertime. Themarketmakermaywishtoacceleratethereductionofaninventoryimbalance,loweringitsrisk,byrequestingtradesfromothers,includingothermarketmakers. Inventoryriskmanagementincludeshedgingwithrelatedfinancialinstruments.Inthemeantime,themarketmakercontinuestoabsorbsupplyanddemandshocksfromitsclients. Thegeneralobjective istobuy lowandsellhigh,balancingtheriskof lossagainstexpectedprofit.Demands for immediacy by customers can vary frommoderate to extremely large, as

illustratedin

Figures

1and

2,

which

were

prepared

by

amajor

broker-dealer

at

the

request

oftheauthorforthepurposeofthisreport,basedontheactualdailyU.S.-dollarinventory4ofcommonsharesofAppleIncorporatedheldbythatbroker-dealerduringacontiguousperiodof2010-2011. Figure1 shows thedaily inventory5 inunitsof sample standarddeviations.Figure 2 is a frequency plot of unexpected shocks to inventory, showing the number of

4Derivativesare includedonadelta-equivalentbasis.5The inventoriesshown includetheeffectofderivatives(onadelta-equivalentbasis)andothereffectiveexposures.

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2 0 2 4 6 8

0.0

0.2

0.4

0.6

0.8

Unexpected shock to inventory (standard deviations)

Frequency

Figure2:AfrequencyplotofunexpectedshockstotheU.S.-dollarpositionofablockmarketmakingdeskinthecommonsharesofAppleInc., includingeffectivepositions impliedbyderivativesandothereffectiveexposures,basedonthedatashowninFigure1.Theshocksarescaledbytheirsamplestandarddeviation.Source: SIFMA-memberdata.

standarddeviations

by

which

the

inventory

changed

unexpectedly

from

one

day

to

the

next.

These shocks are estimated using a simple statisticalmodel,6 which indicates that themarketmakers inventory of this security is expected to revert approximately 20% of thewaytowardnormaleachday.7 Thisimpliesaroughly3-dayexpectedhalf-lifeofinventoryimbalances. Acrossother individualequitieshandledbythesamemarketmaker,thesamestatisticalanalysisshowsthattheexpectedhalf lifeof inventory imbalances isgreatest forthoseequitieswiththehighestbid-askspreadsandthelowesttradingvolume,asonewouldexpectforaproviderofimmediacy.Mostmarketmakingdoneby largebanks involvessubstantialgranularity inbothtrade

frequencyand trade size. Particularly infixed-incomemarkets, tradesarewidelyandunpredictablyspaced intime,andsometimesareeffectivelybyappointment. Forexample,researchbyGoldstein,Hotchkiss,andSirri(2007),Bao,Pan,andWang(2011),andChen,

6TheautoregressivemodelXt+1=a+bXt+Ztwasfittothetimeseriesof inventoryXt oneachtradingdaytduringthesampleperiod.Thepersistenceparameterb isestimatedat0.80,withastandarderrorof0.04. Figure2 isadensityplotofestimatesoftheinventorysurpriseZt,usingkernelsmoothingwithabandwidthof0.146. TheAppendixprovidesaQQplotofthequantilesoftheseshocks,moreclearly indicatingthefattails.

7Evidenceofthetargetingof inventorybymarketmakers isabundant,beginningwiththeworkofAmihudandMendelson(1980).

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Trading day

Inventory

(in

standard

deviations)

0 50 100 150 200 250 300

6

4

2

0

2

Figure3:AplotoftheinventoryoftheU.S.-dollarpositionofamarketmakingdeskofamajorbroker-dealerfora single investment-gradecorporatebond. The inventory levelsare shownafterscalingbyanestimateofthesamplestandarddeviationofthedollarinventorylevelsforthesampleperiod,acontiguousperiodof2010-2011. Source: SIFMA-memberdata.

Fleming,Jackson,

Li,

and

Sarkar

(2011)

shows

that

trades

in

individual

U.S.

corporate

bonds

orindividualcorporatecreditdefaultswapstypicallyoccurafewtimesperdayatmost,intotalacrosstheentiremarket.8Figure 3 shows themarketmakingposition in aparticular investment-grade corporate

bondforthebroker-dealerthatprovidedthedataforFigure1.Duringthe illustratedtimeperiod,themarketmakerfacilitatedsignificantclientsalesthatcausedthemarketmakersinventory tobecomenegative (that is, themarketmakerwasshort). As illustrated, themarketmakertargetedreductionsintheresultinginventoryimbalancesbetweentheseclient-sale events, subject to the constraints of illiquidity and continuing toprovide immediacy.Becausedemandsforimmediacy in individualcorporatebondsaresparselyspacedintime,as illustratedby thestep-like inventorypath shown inFigure3,andbecauseof the rel

8For the sample ofBBB-rated corporatebonds studiedbyGoldstein,Hotchkiss, andSirri (2007), the fractionofdaysonwhichagivenbondwastradedwas26.9%,onaverageacrossbonds.ThesampleofmoreactivelytradedbondsstudiedbyBao,Pan,andWang(2011)weretradedonaverage174timespermonth, intotalacrossallmarketmakers. Forthecreditdefaultswap studyofChen,Fleming,Jackson,Li,andSarkar (2011),The48actively tradedcorporate referenceentities tradedanaverageof10timesdaily,with the topreferenceentity tradinganaverageof22timesperday. Lessactivelytradedreferenceentitiestradedonaverage4timesdailyandinfrequentlytradedreferenceentitiestradedonaveragelessthanonceperday.Theactivelytradedsovereignreferenceentitiestradedonaverage30timesdaily; lessactivelytradedsovereignstradedonaverage15timesperdayand infrequentlytradedsovereigncontractstradedanaverageof2timesdaily.

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ative illiquidity of the corporate bondmarket in other respects, the expected half life ofinventory imbalances inacorporatebond is typicallymuch longer than those forequities.Fortheillustratedcorporatebond,theexpectedhalflifeofinventoryshocksisestimatedatapproximatelytwoweeks,whichistypicalofthecrosssectionofinvestment-gradecorporatebonds

handled

by

this

broker-dealer.

9In general, amarketmakers target inventory level and preferred rate of reversion of

inventory levelstowardthetargetvarywiththeassettype,currentmarketconditions,andthelevelofcapitalthatthemarketmakercurrentlyallocatestotheassociatedtradingdesk.Wheneverthemarketmakerhaslimitedcapacitytowarehouseriskonitsbalancesheet,itstarget inventory level is low,and itavoids requests for immediacy fromclientsthatwouldmove its inventory far from the target inventory level. The lower is themarketmakerstolerance for risk, the less capacity ithas to absorb supply anddemand imbalances fromthemarket,andthemore itmaydemand immediacy for itself fromother investors. Giventhesizeandvolatilityofmodernfinancialmarkets,marketliquidityreliesonthepresenceofhighlycapitalizedmarketmakers.In compensation for bearing the risk that itwill suffer a loss on its inventory due to

unforeseenchangesinfundamentalormarketconditions,orduetotradeswithaparticularlywellinformedclient,amarketmakerrequiresanexpectedreturn.Absentthiscompensation,itwouldbe irrationalforthemarketmakertosupplyimmediacytotheclient.Thegreatertheinventoryriskrelativetothecapitalorrisklimitsallocatedtothemarketmakingdesk,thegreateristherequiredexpectedreturn,otherthingsequal.10 Amarketmakersbidsandoffers apply to trade sizesup toamoderate and conventionalround-lotamount,whichvariesbyasset type. For clientswhowish to tradea largeramount,apriceandquantitynegotiation is likelytoresult inatrade foranamount lessthanthatdesiredbytheclient,or a larger price concession to themarketmaker for taking additional risk, or no trade.Evenmoderate-sizedtradesmayrequirealarger-than-normalexpectedreturntothemarketmaker if they threaten to increase an imbalance in inventory that is already close to themarketmakersrisklimitfortheassettypeorbroaderassetclass.Because an astutemarketmaking trader is aware of changes inmarket conditions, he

or she can often anticipate periods of time over which an imbalance in the demand forimmediacyononesideofthemarketislikelytopresentanopportunitytoprofitbyallowinginventory to diverge significantly from normal. The imbalance is later reduced over timethrough trades at prices that are expected to result in a net profit. This positioning of

9Theestimatedpersistencecoefficientoftheautoregressive(AR1)modelappliedtoweeklyinventorydatafortheillustratedcorporatebondis0.73.Themedianoftheweeklyinventorypersistencecoefficientsacrossallinvestment-gradecorporatebondsin thefirms sample is0.75. When estimatedonadailybasis, the samplemedianof the estimatedpersistencecoefficients is0.938,whichcorrespondstoroughlythesameeffectivehalf life inweeks(because0.9385 isapproximately0.73).10Forsupportingempiricalevidenceonthedeterminationoffederalfundloanrates,seeChapter2ofDuffie(2012),basedon

researchconducted forAshcraftandDuffie(2007).

11
http:///reader/full/equal.10http:///reader/full/equal.10http:///reader/full/equal.10


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inventorytoprofit fromexpectedchanges inmarketprices isanessentialaspectofmarketmaking that improvesmarket liquidity andbenefitsmarketparticipants, as supportedbyconsiderable theoretical and empirical research.11 Ifmarketmakerswere to refrain fromabsorbingsupplyanddemandimbalancesintotheirinventoryinanticipationoflikelypriceimprovements,

the

price

impacts

suffered

by

those

seeking

immediacy

would

be

deeper,

and

thecorrespondingdistortions inpriceswouldbe largerandmorepersistent. BrunnermeierandPedersen(2009)considertheadverseconsequencesonmarket liquidityoftighteningamarketmakersinventoryrisklimit.AsComerton-Forde,Hendershott,Jones,Moulton,andSeasholes (2010)explainand supportwithempiricalevidence,marketmakers face short-run limits on the amount of risk they canbear. As their inventorypositions grow larger(ineitherdirection, longorshort),marketmakersbecome increasinglyhesitanttotakeonmoreinventory,andquoteaccordingly. Similarly,lossesfromtradingreducemarketmakersequity capital. If leverage ratios remain relatively constant, as suggestedby the evidenceinAdrianandShin(2007),marketmakersposition limitsdecreaseproportionately, whichshouldsimilarlyreducemarketmakerswillingnesstoprovideliquidity.Some of the supply and demand shocks absorbed bymarketmakers are idiosyncratic,

tiedtoinvestor-specifictradingmotives.Othersupplyordemandshocksaremoreepisodic,related tomarket-wide events. As amotivating example,Figure 4 illustrates the averageprice impact of deletions of equities from the S&P 500 stock index, and the associatedaverage price reversal over time. These deletions occurwhen the list offirms comprisingtheS&P500 index isadjusted. Theunderlyingdata,provided tomebyProfessorJeremyGraveline, cover theperiod fromDecember 1990 through July 2002, and include 61 suchdeletions.Attheseevents,index-trackinginvestorsareeffectivelyforcedtoimmediatelyselllarge blocks of the deleted equities. Suppliers of liquidity includingmarketmakerswerethereforeofferedsubstantialpriceconcessionsforabsorbingthesupplyshocksintotheirowninventories of the equity. Theyhoped to subsequently profitby laying off theirpositionsover timeathigherprices.12 While the illustratedaveragepathof recovery inpricesafter11Grossman andMiller (1988) provide a seminalmodel. Subsequent theoretical foundations have been provided byWeill

(2007),GrombandVayanos(2002),HeandKrishnamurthy(2009),GrombandVayanos(2010),Lagos,Rocheteau,andWeill(2009),RinneandSuominen(2009),BrunnermeierandPedersen(2009),andDuffie(2010a). Nagel(2009),Lou(2009),RinneandSuominen (2010),andBao,Pan,andWang (2011)offer supportingevidenceofreturn reversalsdue topricepressure. Awealthofempiricalevidenceofprice surgesand return reversalscausedby specialist inventory imbalanceshasbeenprovidedbyAndrade,Chang,andSeasholes(2005),Comerton-Forde,Hendershott,Jones,Moulton,andSeasholes(2010),Hendershottand

Seasholes

(2007),

and

Hendershott

and

Menkveld

(2009).

12As reportedbyChen,Noronha,andSinghal (2004) fora similardata set,deleted stocks suffereda lossofapproximately

8%onthedeletionannouncementdateandanadditional lossof6%betweentheannouncementdateandtheeffectivedeletiondate. Quoting fromChen,Noronha, andSinghal (2004),who cite several studies that further support this remarkablepriceimpactand reversal,Thenegativeeffectofdeletionsdisappearscompletely60daysafter theeffectivedate. Thecumulativeabnormalreturn fromannouncement to60daysafter theeffectivedate isnot significantlynegative,andalwayseconomicallysmall. Relatedstudiesofprice impactsandrecoveriesassociatedwith index recompositions, includingbothdebtandequityindices, includethoseofShleifer(1986),HarrisandGurel(1986),Madhavan(2001),Greenwood(2005),Mitchell,Pulvino,andStafford (2002),WurglerandZhuravskaya (2002),Kaul,Mehrotra,andMorck (2000),Chen,Lookman,Schurhoff,andSeppi(2009),andFeldhutter(2009). Petajisto(2009)providesamodel inwhichthepressure isborneby intermediaries,andapplieshismodeltoexplaintheempiricalevidenceon indexdeletions.

12
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0 10 20 30 40 50 60 70 80 900.2

0.15

0.1

0.05

0

0.05

Cumulativereturn

Days from effective date

Figure4: Averagecumulativereturns fordeletedS&P500stocks,1990-2002. Theaveragenumberofdaysbetweentheannouncementandeffectivedeletiondates is7.56.Thepassageoftimefromannouncementtodeletion for each equity is re-scaled to 8 daysbefore averaging the cumulative returnsduring this periodacross the equities. The original data provided by JeremyGravelinewere augmented byHaoxiangZhu.Source:Duffie(2010a).

deletionsrepresentsasignificantenticementtoprovidersofimmediacyonaverage,therewasneverthelesssubstantialuncertaintyregardingtheprofitabilityofsupplyingliquidityatanyparticulardeletionevent.Weremarketmakerstostandbackfromtheopportunitytoofferimmediacyto investorsanxioustounload largequantitiesoftheaffectedequity,the initialpriceimpactofthesupplyshockwouldbegreaterandthetimeperiodoverwhichthepricedistortionisexpectedtopersistwouldbegreater.13As investors learnovertimeabouttradingopportunitiespresentedbyaspecifictypeof

supplyshocksuchasan indexrecomposition,asset-managementpracticesadjustandtendtoreducethecostoflargedemandsforimmediacy.Theroleofliquidityprovisionbymarketmakersinthefaceoftheparticulartypeofsupplyordemandshockthendeclines.Newformsofdemandandsupplyshocksemerge,however, fromchanges inthe institutionalstructureofmarketsandthemacroeconomy,forwhichmarketmakersareonceagainatthefrontlineof liquidityprovision. This isespeciallytrue inbondandOTCderivativesmarkets,whereessentiallyalldemandsforimmediacyareservedbymarketmakers.Asmotivatedbythelastexample,onceamarketmakerhasabsorbedpartofalargesupply

13Duffie (2010a)provides amodelof the impact on the expectedprice impact of a supply shock and the subsequent timepatternofpricedistortionsassociated,includingtheeffectofreducingtherisktoleranceorquantityofprovidersofimmediacy.

13
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shockintoitsinventory,itbeginstolayoffitspositiontootherinvestorsovertimeathigheranticipatedprices. (Thecaseofademandshockissymmetric.) Immediacy-seekinginvestorswilltradeatthemarketmakersaskprice.Forthesetrades,themarketmakerhopestoprofitfromboth thebid-ask spreadand also from the expected recovery inprice from the timeat

which

the

market

maker

first

expanded

its

inventory.

The

price

is

expected

to

increase

during thisperiodbecauseof thediminishingoverhangof inventoriesheldby suppliersofimmediacy.Themarketmakermayatthesametimeseekimmediacyfromother investors,includingothermarketmakers,inordertoreduceitsinventoryinaprudentlyrapidmanner.Whenitseeksimmediacyfromotherstoloweritsexcessinventory,themarketmakerexpectstoprofitfromanypricerecoverysincetheoriginalsupplyshock,lesstheeffectivespreadthatitpaystoitscounterparties.Amorepassiveapproachofwaitingtoreduceitsinventoryovertimeexclusively through trades initiatedbyclientswouldexpose themarketmaker totheadditionalriskassociatedwithamoreprolongedexposuretounexpectedchangesinprice.Theincentiveofamarketmakertoprovideimmediacyisincreasingintheexpectedprofit

associatedwithbothanticipatedchangesinmarketpricesandfromtheneteffectofbid-askspreads(receivednetofpaid).Asanother illustration,Figure5, fromKulak (2008), shows theaveragepatternof eq

uityprices around the time of seasoned equity offerings. In this case, anticipation of theannounced supply shock causes theprice todecline, on average, as the issuancedate approaches.Duringthisperiod,marketmakersandotherprovidersofliquiditygenerallywishto reduce their inventory below a normal target level in order to make space on theirbalancesheetsfortheanticipatednewsupply. Oncesuppliersof immediacyhaveabsorbedthe supply shockata relativelydeepaveragepriceconcession, they layoff their inventoryover time toother investorsatanexpectedprofit. The longer theyarewilling tohold inventory,thegreatertheexpectedprofit,accompaniedofcoursebyanextendedexposuretolossassociatedwithunexpected fundamentalnews.14 Marketmakersandunderwritersareamongthemostimportantprovidersofliquidity.Figure 6, provided to the author byProfessorHonjunYan, shows the impact ofU.S.

Treasurynoteauctionson theassociated treasuryyields. Noteyieldsgoupas thedateoftheanticipatednewsupplyof treasuriesapproaches,and then recover in subsequentdays.FlemingandRosenberg(2007)showthatTreasurydealersadjusttheirpositionstoabsorbthese issuancesupplyshocks. Theydescribehowdealersseemtobecompensated fortherisksassociatedwiththese inventorychangesviapriceappreciationthesubsequentweek.Thefigureshowsthattheauctionsupplytemporarilyraisesnotonlytheyieldsofthesecurityissued,butalsothoseofthepreviouslyissued(offtherun)treasuriesofthesamematurity14ThatsecondaryofferingsaremadeatsubstantialpriceconcessionshasbeendocumentedbyMikkelsonandPartch(1985).

AtleastasearlyastheworkofScholes(1972),researchershavefocusedonthepresenceoftemporarypriceimpactsatsecondaryequityissuances.AdditionalempiricalevidenceisofferedbyLoughranandRitter(1995),Chaisurote(2008),andGaoandRitter(2010).

14


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20 15 10 5 F O +5 +10 +15 +20

0.96

0.97

0.98

0.99

1

1.01

1.02

1.03

1.04

1.05

1.06

trading days

average

price

avg. rel. mkt. price

avg. rel. offer price

Figure5:Averagepricedynamicsaroundseasonedequityofferings.Thefigure,kindlysuppliedtotheauthorbyJanPeterKulak, covers3850U.S. industrialfirms thatundertookafirm-commitmentpublic seasonedoffering in theUnitedStatesbetween1986and2007. Theplotted line shows theaverageacross issuancesof theratioof secondarymarketpriceof theequitytotheclosingpriceoftheequityon theofferingdate.Becauseofferingsdifferinthenumberoftradingdaysbetweenthefilingannouncementandtheofferingdate,thetimesbetweenfilingandofferingdatearerescaled interpolatedtotheaverageacrossthesampleofthenumberoftradingdaysbetweenthefilingandtheissuancedate. Source:Kulak(2008),publishedinDuffie(2010a).class,because their returnsarehighly correlatedwith thoseof the issuednote. Althoughtreasurysecuritiesareexemptedfromtheproposedrule,thesameprinciplesapplytoothermarkets, toanevengreaterdegreegiven thehigh liquidityof treasurymarkets relative toothersecuritymarkets.For example,Figure 7, fromNewmanandRierson (2003), shows the expectedpattern

ofyield impactsaround the timeofa largecorporatebond issuance. In thisexample, theillustratedimpactisforcorporatebondsoffirmsotherthantheissuer,thatareinthesameindustry

as

the

issuer,

the

European

telecom

industry.

When

acompany

in

this

sector

scheduled a significant issuance of bonds during the period 1999-2001, the entire relatedmarketforEuropeantelecombondssufferedfromhigherbondyields.ThefigureshowstheestimatedpathofyieldimpactsonEuropeantelecombonds,notincludingthoseoftheissuer,DeutscheTelekom,associatedwithaparticular16-billion-Euro issuance.Asforthecaseoftreasurynoteissuances,yieldsincreasedastheissuancedateapproached,andthenrecoveredtowardnormal. Thedegree towhich the yields of corporatebondsare adversely affected

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5 0 56

4

2

0

2

Time(days)

y(t)y(0)(Bas

ispoints)

On the run 2year

5 0 56

4

2

0

2

Time(days)

y(t)y(0)(Basispoints)

Off the run 2year

5 0 56

4

2

0

2

Time(days)

y(t)y(0)(Bas

ispoints)

On the run 5year

5 0 56

4

2

0

2

Time(days)

y(t)y(0)(Bas

ispoints)

On the run 10year

5 0 56

4

2

0

2

Time(days)


Off the run 10year

5 0 56

4

2

0

2

Time(days)


Off the run 5year

Figure6:YieldelevationattheissuanceofU.S.Treasuries,with95%confidencebands.Thefigure,kindlyprovidedtotheauthorbyProfessorHonjunYan,coversU.S.TreasuryissuancesfromJanuary1980toMarch2008. Yieldsarebasedonaveragesofbidandaskpricesobtained fromCRSP.Auctiondatesare fromtheU.S.TreasuryDepartment. The sample includes 332 2-yearnoteauctions, 210 5-yearnote auctions, and132 10-yearnote auctions. For eachmaturity, thedifferencesbetween theyield on the issuancedate andtheyieldondateswithin5daysoftheissuancedateareaveragedacrossissuances,forbothon-the-runandoff-the-runnotes. Source:HonjunYan,publishedinDuffie(2010a).by issuanceshocks isgreaterthanthatfortreasuriesbecausethe liquidityofthecorporatebondmarketislowerbycomparison,andbecausecorporatebondsareriskierthantreasuries,exposing suppliersof immediacytogreater inventoryrisk. Ifmarketmakerswereto lowertheirrisk limits,orhave inflexiblerisk limits inthe faceofmarket-widesupplyshocks,theyieldimpactsoftheseandothersupplyshockswouldbedeeperandmorepersistent.15Figure 8 illustrates the concept that, particularly in an over-the-countermarket, the

provisionofimmediacyisfacilitatedbyanetworkofmarketmakersandinter-dealerbrokers.Amarketmakerisabletoprovideimmediacymoreefficiently(atlowercosttoclientsandatlowerrisktoitself),throughtheopportunitytolayoffpositionswithothermarketmakers,15Chen,Lookman,Schurhoff,andSeppi(2009)documenttheimpactontheyieldsofcorporatebondsintheautomotivesector

causedbythedowngradeofGeneralMotors in2005. Because some institutional investors incorporatebondsarerequiredtohold only investment-grade bonds, the prospect of adowngrade caused forced sales. Chen, Lookman, Schurhoff, and Seppi(2009)areabletodemonstratethe impactofthissupplyshock,aboveandbeyondthe implicationsofthe informationrelatedtothedowngrade.

16
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20 0 20 40 602

0

2

4

6

8

10

12

14

OtherBond YieldSpread Reaction

Days Relative to Issuance Date

BasisPoints

Figure7:Capitalimmobilityinthetelecomdebtmarket.TheestimatedimpactsontheyieldsofEuropeanTelekom issuers,not includingDeutscheTelekom,associatedwithaparticular16-billion-Euro issuancebyDeutscheTelekom,usinganeconometricmethodexplainedbyNewmanandRierson(2003).Source:NewmanandRierson(2003),publishedinDuffie(2010a).

whomaybebetterawareofultimateinvestorswhoareinterestedintradingintheoppositedirection. This intermediationof immediacyoccursthroughdirectdealer-to-dealertrades,or indirectly through inter-dealer brokers. Because of search and contracting frictions aswell as thebenefitof confidentiality in reducingprice impacts for large trades, it is ofteninefficient forclient investorstonegotiatesimultaneouslyanddirectlywitha largenumberofmarketmakers. It isevenmorecostly forultimate investorstoconduct largetrades,ortrades in illiquidproducts,directlywithultimate investors. Instead, investorsmayrequestquotes fromoneora subsetofmarketmakers.16 These contacts can lead toa tradewithaparticularmarketmaker,whomaythenwishtorebalanceitsinventoryrelativelyquicklythrough the inter-dealernetwork. This is oftenmore efficient for themarketmaker thanrequesting immediacy from anotherultimate investor, orwaiting for anultimate investorwhomightwish totrade in theoppositedirection. Ineffect, the inter-dealernetworkactsasabroadermechanismfortransmittingsupplyanddemandshocksfromultimateinvestorstoultimateinvestors.17 BechandGarratt(2003)providestrongevidenceoftheinter-dealernetworkeffectinre-distributingsupplyanddemandshocksinthefederalfundsmarket.16Largeinstitutionalinvestorscaninitiaterequestsforquotesordealerruns,sometimesthroughswapexecutionfacilities

(SEFs).Thecostofasequentialsearch,onemarketmakeratatime, isanalyzedbyZhu(2012).17ConcernsoverthetransparencyandcompetitivenessofOTCmarketsremain,andhavebeenpartiallyaddressedbyrecent

requirementsforpricetransparencyincorporatebondmarkets,andbytheDodd-Frankrequirementsfortransactionsdisclosureandtheuseofswapexecution facilities inthestandardizedOTCderivativesmarket.

17
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4

Figure 8: A schematic of an over-the-countermarketwith a core inter-dealermarket inwhichmarketmakersandinter-dealerbrokersactasanetworkthatcollectivelyprovidesimmediacytoultimateinvestors.

ImpactoftheProposedRuleonInvestorsand IssuersTheproposedrulewoulddiscouragetheprovisionof immediacybymarketmakers,particularlythroughthethreatofsanctionsforsignificant increases inmarketmakingriskorforsignificantprofitscausedbypricechanges(asopposed toprofitsassociatedwithabid-askspreadrevenues).Atpage94,theAgencieswritethatMarketmakingandrelatedactivitiesseektogenerate

profitabilityprimarilybygeneratingfees,commissions,spreadsandotherformsofcustomerrevenue that are relatively, thoughnot completely, insensitive tomarket fluctuations andgenerallyresult inahigh levelofrevenuerelativetoriskoveranappropriatetime frame.Thisstatementdoesnotaccuratelycharacterizemarketmaking.TheAgenciesexplanationoftheirproposed rulesclearly indicatesthe intentiontousethevariousproposedriskandprofitmetrics to restrictmarketmakingactivities to those consistentwith thisdefinition.For example, atpage 94, immediatelybefore this characterization ofmarketmaking, onereads: TheAgencies expect that these realized-risk and revenue-relative-to-realized-risk measurementswouldprovide informationuseful inassessingwhether tradingactivitiesareproducingrevenuesthatareconsistent,intermsofthedegreeofriskthatisbeingassumed,withtypicalmarketmakingrelatedactivities. Atpage92,theAgenciessuggesttheywilluse theproposed riskmetrics totodeterminewhether theseactivities involveprohibitedproprietarytradingbecausethetradingactivityeither is inconsistentwithpermittedmarketmaking-relatedactivitiesorpresentsamaterialexposuretohigh-riskassetsorhigh-risk

18


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tradingstrategies.Atpage93:Significant,abruptorinconsistentchangestokeyriskmanagementmeasures,suchasVaR,thatareinconsistentwithpriorexperience,theexperienceofsimilarlysituatedtradingunitsandmanagementsstatedexpectationsforsuchmeasuresmayindicateimpermissibleproprietarytrading.Were

this

approach

to

be

reflected

in

the

Agencies

final

rule,

the

intent

of

Congress

toexemptmarketmakingbybankswouldbethwartedandU.S.financialmarket liquiditywouldsuffer,withtheadverseconsequencesoutlinedinSection2ofthisreport.Undertheproposed implementingrules,marketmakerswouldretaintheabilityand in

centivetoabsorbonlymoderatelysizeddemandsforimmediacy. Itispreciselythroughtheirabilitytoserviceheighteneddemandsforimmediacy,however,thatmarketmakersmitigatethemostsignificantassociatedpricedistortionsandexecutioncoststoinvestors.Theabilityofmarketmakers tobufferunexpectedly largesupplyanddemand imbalancesdependsonsignificantandflexiblemarketmakingcapacityandontheincentivetoprofitfromexpectedpricechanges.Weretheproposedruletobeimplemented,marketmakerswhoabsorblargedemandandsupplyshocks intotheir inventorieswouldexperienceadeterioration intheproposedmetricsfortheirmarket-makingrisk,andtheassociatedthreatofregulatorysanction.Theywouldalsobelessinclinedtoabsorbtheassociatedrisksgiventhelikelysanctionsforsignificantprofitsfrompricechanges.Further,undertheproposedrulesfortradercompensation,marketmakingtraderswouldhavesignificantlylowerincentivestoaccepttradesinvolvingsignificantincreasesinriskorprofit.Undertheproposedrule,imbalancesinthedemandorsupplyofimmediacywouldthere

fore cause larger andmorepersistentdistortions inmarket prices. Price discoverywouldsuffer.Homeowners,businesses,andsomemunicipalitieswouldfacehigherborrowingcosts.Firmswould facehigher costs for raisingnew capital. These increased costswouldoccurdirectlyintheformofhigherpriceimpactsatthepointoffinancing,andindirectlyfromthelowerappetiteof investorstoownsecuritiesthatwouldtrade inthinnerandmorevolatilesecondarymarkets.InadditiontotheresearchthatIhavealreadycited,thereissignificantempiricalevidence

that a limited risk-taking capacity of marker makers leads to price distortions.18 As arelativelyextremebutillustrativeexample,MitchellandPulvino(2009)describeadramaticdistortionincorporatebondyieldsthataroseduringthefinancialcrisisduetoaninsufficientrisk-taking capacityofmarketmakers. As shown inFigure9, corporatebondyieldswereelevated well above those implied by credit default swap (CDS) rates.19 The difference18For example,Meli (2004) found evidence that changes in dealer capital are strongly related to changes in swap spreads

(thedifferencebetweenswapratesandtreasuryrates). Etula(2009)describeshowvariationovertime inbroker-dealerassetsissignificantlycorrelatedwithcrudeoilreturns.Furtherevidenceontherelationshipbetweendealerrisk-bearingcapacityanddistortions inriskpremia isprovidedbyAdrian,Etula,andShin(2009)andAdrian,Moench,andShin(2011).19Inafrictionlessmarket,theCDSrateis,withinasmalltolerancefortechnicalcontractdifferences,equaltotheyieldspread

on apar bond of thematurity of theCDS of the same issuer, that is, the bond yield less the associated risk-free yield. If,forexample, thebasis foraparticularcorporatebondbecomesnegative,as illustrated inFigure9,onecouldshortarisk-free

19
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between theCDS-implied bond yield and the actual bond yield is known as the basis.TheexceptionalCDSbasisviolationsthatappearedduringthefinancialcrisisacrossbroadportfoliosofinvestment-gradeandhigh-yieldbondswereduetotheextremelylowlevelsofcapitalofdealerbanks.20 Investment-gradecorporationsissuingbondsinlate2008andearly2009

had

to

pay

roughly

2%

higher

interest

rates

due

to

this

market

inefficiency.

For

lower

ratedfirms,asillustrated,thedistortioninborrowingrateswouldhavebeenfargreater,forany that actually attempted to issuebondsduring thisperiod. As largedealers regainedsomebalance-sheetcapacity,theCDSbasiswentbacktowardnormal,asillustrated.Musto,Nini,andSchwarz(2011)showthatevenU.S.treasurypriceswereseverelydis

tortedat theheightof thefinancial crisis througha lossofmarket liquidity. ParticularlyaroundDecember2008,portfoliosof treasuriespromising equivalent cashflowswereoftentradingatsubstantialpricedifferences. Thecornerstoneoftreasurymarket liquidity isthemarketmakingdesksofprimarydealers. AlthoughU.S. treasuriesareexempted from theVolckerRule,many important classes of securities, that already trade in less liquidmarkets than those forU.S. treasuries, will be affected. Asmentioned in Section 2, foreigngovernmentshaveaskedthattheirbondsalsobeexempted.The incentiveanddiscretion tosupply immediacyby takingextra risk in lightofextra

expectedprofit isalso important at the levelof an individual trader onamarket-makingdesk.Theproposedruleworldleadthecompensationofmarket-makingtraderstobemorelike thatofflow-basedbrokerageagents. Coupledwith the reputational riskof exceedinglikely regulatorynorms forlow-riskmarketmaking thatwould arise from theproposedmetrics, amarketmaking traderwould often avoid taking the discretion needed tomeeta customersdemand for immediacy. Under theproposed rule, a traderwould frequentlyfailtooffertwo-sidedmarketsforsignificantquantitiesatefficientprices. Forexample,theproposedrulewouldencourageatraderfacedwiththeextrariskoftakingalargepositiontoquotepricesforonlyalimitedfractionofthecustomersdesiredamount.Whentheefficientapproachtoatradeenquirywithextrarisk isawideningofthebid-askspread,especiallywhen facingawell informedclient,theproposedmetricswoulddiscouragethetrader fromtakingthepositionatall,orencouragethetradertotakethepositionatasmallexpectedprofitrelativetotheriskof loss,outof fearofdrawingattentiontohimselforherselfovertradesthatadverselyaffecttheregulatorymetricsoftheproposedrule. Indeed,oneofthebond, investtheproceeds inthecorporatebond,andbuydefaultprotectiononthecorporatebondwithacreditdefaultswap.Puttingaside some technical issuesand ignoringcounterparty risk, thenet incomeof this strategyperyear,atnonet initialinvestment, istheprincipaldebtpositionmultipliedbytheabsolutemagnitudeofthebasis. Ifthebasisbecomesnegative,theoppositetrade is likewisehighlyprofitable,althoughholdingashortpositionincorporatebonds issomewhatcumbersomeandcaninvolveextracostsorrisks. Institutionaldetailscancausethebasistodivergesomewhatfromzero. SeeDuffie(1999).TheCDSbasiscanalsobeelevatedbycounterpartyrisk,althoughthiseffectistinybycomparisonwiththebasisshowninFigure9.20ExploitingtheCDSbasisarbitragecallsforasubstantialamountofbalance-sheetcapacityatdealerbanks,bothtomake

markets intheunderlyingbond(whichcallsforfindingorholdingtheunderlyingbonds)andtohandletwoCDScounterpartypositions,onewiththearbitrageurandonewithacounterpartytakingtheoppositeposition.Exacerbatingthecapitalshortageofdealers, theamountofcapitalnecessary toholdcorporatebonds increasedbecauseofan increase inthehaircutappliedtofinancecorporatebonds intherepomarkets,asexplainedbyMitchellandPulvino(2009).

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2005 2006 2007 2008 2009 2010

700

600

500

400

300

200

100

0

100

Date

CDS

basis

Investment grade

High yield

Figure9:AveragebasisofU.S.corporatebondportfolios.TheCDSbasisforagivenbondisthedifferencebetweentheyieldspreadofabondthatisimpliedbytheassociatedcreditdefaultswap(CDS)rateandtheactualbondyieldspread. TheCDSbasis isnearzero in frictionlessmarkets. Asshown, theaverageCDSbasis across portfolios ofU.S. investment-grade bonds and high-yieldbondswidened dramatically duringthefinancialcrisisand thennarrowedas thecrisis subsided. Theunderlyingdata,kindlyprovided to theauthorbyMarkMitchellandToddPulvino,coveranaverageof484investment-grades issuersperweekand208high-yieldissuersperweek. Source:MitchellandPulvino(2010).,published inDuffie(2010a).

proposedmetricsseemstosuggest that trades shouldnotbeundulyprofitable, relativetowhattheywouldbeathistoricallynormalbid-askspreads. Intheeventthatatradeturnsouttobeoverlyprofitablebecauseofanunexpectedlyfavorablepricechange,wouldatraderthenhaveanincentivetoincuranoffsettinglossinordertoavoidscrutiny? Similarly,inthefaceofalikelymarket-wideimbalanceofsupplyordemand,amarketmakingtradershouldhavethediscretionandincentivetosignificantlyrepositionhisorherfirmsinventoryinorderto absorb some of the supply imbalances. Theproposed rule, including its compensationnorms,wouldreducethetradersdiscretionandincentivetodoso,exacerbatingtheadverseconsequencesthatIhavedescribed.Atradersincentivesforunduerisktakingcanbeheldincheckbyvestingincentive-basedcompensationoverasubstantialperiodoftime.Pendingcompensationcanthusbeforfeited

ifatradersnegligencecausessubstantial lossesor ifhisorheremployerfails. Thepoolofpendingcompensation isthuseffectivelycontributing tothecapitalof thefirm,consistentwitharecommendationoftheSquamLakeGroup.2121SeeTheSquamLakeReport: Fixing theFinancialSystem,PrincetonUniversityPress,2010. Iamoneof15authors.

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5 ConcludingRemarksSection13ofBHCAct(Section619oftheDodd-FrankAct)exemptsmarketmakingfromitsproprietarytradingrestrictionsonbankstotheextentthatanysuchactivitiespermittedby this subparagraph [including marketmaking related activities] are designed not toexceedthereasonablyexpectedneartermdemandsofclients,customers,orcounterparties.Fromtheviewpointofimpactonmarketparticipants,includingultimateinvestorsandthoseseekingtoraisecapitalandfinancethemselves,IbelievetheAgenciesinterpretationofthislanguage isoverlynarrowandwouldcauseunduecoststotheeconomy. TheAgenciesdidnotprovideacost-benefitanalysisthatsuggestsotherwise. Thepotential forsystemicriskand costs to theDeposit InsuranceFundassociatedwithmarketmakingbybankscanbetreatedmoreeffectivelythroughregulatorycapitalandliquidityrequirements. Inanycase,if implemented, theproposed rule could inadvertently increase systemic riskbecauseof amigration

of

market

making

activities

to

outside

of

the

regulated

banking

sector,

as

Ihave

outlinedinSection2.Capital and liquidity requirements are amore direct and effectivemeans of handling

the legislatedexemption formarketmaking. Theproposed restrictionsonmarketmakinginstead attempt to identify and eliminate specific patterns of trading. This attempt todisentangle those trades thathavemarketmaking intent from those that donot is likelytobeeffectiveonly inreducingthecapacityofmarketmakingservicesprovidedbybanks.Capitaland liquidityrequirementsdirectlyconsiderthesoundnessofafinancialinstitutionand its potential for causing systemic risk and costs to theDeposit InsuranceFund. Inthe case ofmarketmaking, capital requirements treat risk on a portfolio-wide basis, anappropriateapproach.Leadinguptothefinancialcrisisof2007-2009,theregulatorycapitalandliquidityrequire

mentsoffinancialinstitutionswereclearlyinsufficient.Theserequirementsshouldcontinueto be strengthened as deemed appropriate by regulators to robustly protect theDepositInsuranceFund and the soundness of the financial system. An alternative to heightenedcapital and liquidity requirements couldbe some form of ring-fencing requirement thatallowsseparatelycapitalizedbankruptcy-remotemarket-makingaffiliates,anapproachunderadoption in theUnitedKingdom. Thisapproach is significantly lessefficient from theperspectiveofriskdiversification,althoughgenerallyconsistentwiththeprimarylegislativemotive of insulating banks from proprietary trading risks. In any case, whethermarketmaking isconductedbybanksorothers,marketmakersshouldberequiredtomeetrobustcapital and liquidity requirements. A crucial point is that themarketmaking and otherriskstakenbyafinancialinstitutionareunsafepreciselywhentheyarelargerelativetotheinstitutionscapitalandliquiditybuffers.

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6 AdditionalQuestionsandAnswersIoffersomequestionsthatmayberaisedbymyreport,andresponses.1. Ifsignificantmarketmakingactivitiesarepermitted,wouldntbanksbe inaposition toconductproprietarytradingthathasnomarketmakingintent?Thelegislatedexemptionformarketmaking createsanunfortunatemoralhazard that cannotbe curedby theAgencies rulewriting. Some forms ofproprietary trading that are clearlyunrelatedtomarketmakingcanbeidentifiedandproscribed. EvenwiththeAgenciesproposedrestrictions,however,therewillremainanincentiveandabilitytodisguiseasexemptedmarketmaking certain forms of speculative trading that do not serve an ultimateobjective ofprovidingmarketmaking services to clients. As theAgencies recognize,effectivemarketmakinginvolvessometradesthataresimilaroridenticaltotradesthatwouldbeconductedwithoutmarket-makingintent.22 Intentisdifficulttomeasureandthereforetoregulate.Theproposedruleattemptstodosowiththeuseofcriteriathatareintendedtoensurethatthebankingentityisengagedinbonafidemarketmaking.Iexpectthatthisintentwouldbenotachieved. Instead,anapplicationoftheproposedcriteriawouldleadto lessmarketmaking.

2.Hasnt thefinancial crisis shown us that derivatives trading by large banks is an important source of systemic risk? TheDodd-FrankActaddresses systemic risk in themarketforOTCderivativesbyheightenedrequirementsforcollateral,arequirementforthecentralclearingofstandardizedproducts, requirements forpost-tradepricetransparency,andtherequirementtotradestandardizedderivativesinswapexecutionfacilities.Strongcollateralstandardsandeffectiveclearingwilllowercounterpartyrisk.Alloftheserequirementsarelikelytoreducethedegreeofconcentrationofmarketmakingamongasmallsetofsystemicallyimportantbanks.TheBaselIIIaccordsubstantiallyincreasesthecapitalandliquidityrequirementsassociatedwithOTCderivatives.Thesemeasures therefore significantlyalter thecost-benefit tradeoffs tobeconsideredwhenimplementingtheVolckerRule. Inanycase, further improvements inthecost-benefittradeoffassociatedwithmarketmakingriskaremoreefficientlyachievedthroughfurtherimprovementsincapitalandliquidityrequirements,whereverdeemedappropriatebyregulators,thanbytheproposedrule.

3.Are theBasel III regulatory capital and liquidity requirements associatedwithmarketmakingsufficient?Thisisasubjectformorestudy.TheBaselCommitteeonBanking

22Atpage53, theAgencieswrite: Inparticular, itmaybedifficult todeterminewhetherprincipal riskhasbeen retainedbecause (i) the retention of such risk is necessary to provide intermediation and liquidity services for a relevant financialinstrument or (ii) the position is part of a speculative trading strategy designed to realize profits from pricemovements inretainedprincipalrisk.

23
http:///reader/full/intent.22http:///reader/full/intent.22http:///reader/full/intent.22


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Supervision (2011) iscurrentlyconductingafundamentalreviewofcapitalrequirementsforthetradingbooksofregulatedbanks.Theirresultsaretobereleasedin2012.ItmakessensefortheAgenciestoadoptaconservativeapproachfromtheviewpointofsafetyandsoundnessofthefinancialsystem,andtoharmonizecapitalandliquidityrequirements

across

regulatory

jurisdictions

so

as

to

avoid

asignificant

incentive

for

marketmakingtomigrateortomorphunsafely.

4.Donthighercapitalrequirements lower the incentivesofbanks toprovidebanking services?Highercapitalrequirementsarecostlytocurrentshareholdersbecausetheylowerthevalueofthelimited-liabilityoptionheldbyequityowners.Thisleadstoarationalreluctance by banks to raise capital even in some cases forwhich additional capitalwould significantly reducedistress costs, aproblemknownas debtoverhang. (SeeChapter4ofDuffie(2010b).)Relativelyfewbankingactivitiesthatareprofitableatlowcapitallevelswouldwouldceasetobeprofitableathighercapitallevels,atleastacrosstherangeofcapitalrequirementsthatare likelytobeconsidered. Ihavenotseenanyreliableevidenceoraconceptualfoundationforthecontraryview.Thereducedreturnonequityofabankingactivityimpliedbyhigherequitylevelsdoesnotitselfchangethesetofprofitablebankingactivities, apoint explained indetailbyAdmati,DeMarzo,Hellwig, andPfleiderer (2011).23 There isan exception, to the extent thatabank istoobig to fail. In this case,ahigher capital requirementalso reduces the effectivegovernmentsubsidytothebankassociatedwith lowerdebtfinancingrateschargedtothebankby creditorswho consider the likelihoodofgovernment support in loweringtheir

expected

default

losses.

A

reduction

of

this

effective

subsidy

through

higher

capital

requirementswouldreducethesetofprofitableinvestmentsbyabank,includingsomeofthoseassociatedwithlendingandmarketmaking. Ihavenotconsideredtheimpactofhighercapitalrequirementsthroughthepotentiallossofthissubsidy.Leadinguptothefinancialcrisisof2007-2009,itseemsapparentthatregulatorycapitalandliquidityrequirementswerenoteffective,andthatmanyofthelargestU.S.financialinstitutionswerenotwellsupervised.Thiscouldbeviewedasanargumentagainsttheeffectivenessofcapitalandliquidityrequirements,andthereforeinfavorofreducingmarketmakingriskbyothermeans,suchastheproposed implementationoftheVolckerRule. Inmyview, the failure of capital and liquidity requirements tobe effective in the financialcrisisof2007-2009canbecorrected.TheBaselIIIrequirementsareanexampleofthat.

5. Isnt it true that the losses incurredbybanks throughmarketmakinghavebeenresponsibleforpastbankingcrises?No.Mostbankingcrisesarecausedby lossesthatbanksincur through loandefaults,as explainedbyReinhartandRogoff (2009). Lossesdue

23BoltonandSanama(2010)describeswhycontingentcapitalmaybearelativelycosteffectiveapproachtomeetingcapitalrequirements.

24
http:///reader/full/2011).23http:///reader/full/2011).23http:///reader/full/2011).23


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to borrower defaults on conventional banking activities, such as loans to sovereigns,mortgages,andloanstocommercialrealestateprojects,tendtobefargreaterinmagnitudethan lossesonmarketmaking. Thiswascertainlytrue inthefinancialcrisisof2007-2009.Thatcrisiswasneverthelessexacerbatedbytheproprietarytradinglossesofsome

large

broker

dealers,

particularly

Bear

Stearns,

Lehman

Bothers,

Merrill

Lynch,

andthebroker-dealeraffiliatesofCitibankandsomeforeignbanks.24 AlthoughIhavenotseenasystematicstudyoftheavailabledata,mostofthelargesttradinglossesseemtohavebeenassociatedwithformsofproprietarytradingthatarenotmarketmakingorotherwiseexemptedbysection13oftheBHCAct. (ThecaseofBearStearnsmaybeanexception.) AccordingtotheUnitedStatesGovernmentAccountabilityOffice(2011),trading lossesduringthe lastfinancialcrisiswererelativelysmall forthe largestbankholdingcompanies, includingmarketmakingandallotherproprietarytrading-relatedgainsorlosses. Figure10showstotal industrysecuritiestradinggainsandlossesfrom2007 to2011,breakingout those for the largestdealers.25 Iamnotawareof reliabledatabearingonthemarket-makingcomponentofthesetotaltradinggainsand losses.Marketmaking risksmake relatively high demands on a banks liquidity, in proportiontoassets,becauseofcontractualmarginandcollateralrequirements,thepotentialadverse effectsoffire salesandothermarketdislocations, and theneed foramarketmakertocontinuetoofferclientsimmediacy,includingthroughtradesthatdraincashfrom themarketmaker. Amarketmaker that refuses toprovide significant liquiditytoclientsrisks signaling itsfinancialweakness,whichwould likelyexacerbate itsownliquiditypositionby creatingan incentive forcreditors, counterparties,andclients tofurtherwithdraweffectivefinancing. (SeeDuffie(2010b),Chapters2and3.)

6.Dont the proposed riskmetrics provideuseful additional information to theAgenciesforsupervising themarketmakingrisksofregulatedbanks?Yes. Someoftheproposedmetrics, such as the Risk and Position Limits metric, VaR, Stress VaR, or RiskFactorSensitivities,wouldprovideusefulsupervisoryinformation,especiallyiftheyaremeasuredeffectivelyand foracarefullyconsideredmenuofassetclasses. TheUnitedStatesGovernmentAccountabilityOffice (2011)points out that the largest sixbankholding companieshadproprietary trading losses that frequently exceeded theirVaRestimates,more frequentlythanconsistentwithaneffectiveriskmeasure. Thedesignandsupervisionoftheseriskmeasuresshouldberevisited,giventhattheyareusedfor

24ThesignificantlossesoftheRoyalBankofScotlandincredittradingarereviewedinSection4.1ofthereportonthefailureofRBSoftheFinancialServicesAuthority(2011).25Asofthefourthquarterof2008,theMajorFirmsareBANCOFAMERICASECURITIESLLC,BARCLAYSCAPITAL

INC.,CITIGROUPGLOBALMARKETS INC.,CREDIT SUISSE SECURITIES (USA)LLC,DEUTSCHEBANKSECURITIES INC.,GOLDMAN,SACHS&CO.,J.P.MORGANSECURITIES INC.,MERRILLLYNCH,PIERCE,FENNER&SMITHINCORPORATED,MORGANSTANLEY&CO.INCORPORATED,UBSFINANCIALSERVICESINC.,UBSSECURITIESLLC,andWACHOVIASECURITIES,LLC.Since2009,SIFMAdoesnotreportthe individualnamesofthetop10firms.

25
http:///reader/full/banks.24http:///reader/full/banks.24http:///reader/full/dealers.25http:///reader/full/dealers.25http:///reader/full/banks.24http:///reader/full/dealers.25


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Q107 Q108 Q109 Q110 Q111

25

20

15

10

5

0

5

10

15

Quarter

Trading

gain

($

billions)

Total

Top10

Figure10: Quarterlytradinggainsand lossesofUSbrokerdealers,2007-2011, intotal,andforthe largestdealers. FINRAdefines thesedataasrealizedandunrealizedgainsand losseson securitiesheld for saleintheordinarycourseofbusiness(netofdividendsand interestearnedonsuchsecuritiesbutnotreducedbyfloorcostsortaxes).ThedataarefromtheSECsFinancialandOperationalCombinedUniformSingle(FOCUS)Report regulatoryfilings,andcover theU.S.domesticoperationsofbroker-dealerunitsdoingapublic business. Before 2009, the data shown here for the Top 10 are instead reported by SIFMA formajorfirms,whicharesometimes12or13innumber. Since2009,SIFMAprovidesdatafortheTop10withoutreportingtheindividualfirmnamescomprisingthesetop10firms.Datasource: SIFMADataBank.

supervisorypurposesandalsofordeterminingcapitalrequirements. Ialsosuggesttheuseofcounterpartyriskexposuremeasures,notonlytotheriskofcounterpartydefaultbut also topotential gains and losses tomajor counterparties for each of a specifiedlist of systemically important scenarios. Thesemeasures should coverboth exposuretochanges inmarketvalueandalsoexposuretocashflows.Thecollectionandusebyregulatorsof theseandother riskmeasures for supervisorypurposes, ifdonebroadlyacross bank and non-bank financial firms, could improve the ability of regulators todetect andmitigate risks to individual institutions and to the financial system as awhole.Thecollectionanduseoftheseandsimilarmetricsisalreadyauthorizedunderexisting broad supervisory mandates of the Agencies, including those applicable tobanks, registeredbrokerdealers,andnon-bankfinancialfirms thatwillbedesignatedbytheFinancialStabilityOversightCouncilassystemicallyimportant.

7.Wouldnt it be prudent to lower the risk to the economy associatedwith bankfailuresbyforcingbanks tostopmakingmarkets?CongressconcludedotherwisebyexemptingmarketmakingfromtheVolckerRule. IbelievethatCongressgotthisright.Although

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separatingmarketmakingfromtraditionalbankingwouldmakebankslesscomplexandthussimplerforregulatorstosupervise,systemicriskcouldneverthelessrise.LargebrokerdealerswouldbeoutsideoftheregimeofBaselIIIcapitalandliquidityrequirements,withadifferentsupervisoryregimeandwithreducedaccesstolender-of-last-resortliquidity

from

the

central

bank.

As

demonstrated

during

the

financial

crisis

of

2007-2009

and in the currentEurozone crisis, access to centralbank liquidity canbe crucial inmitigatingthedamagecausedbyafinancialcrisis. Ifthere isanargument in favorofseparationofmarketmakersfromconventionalregulatedbanks,itwouldbemoreeasilybased insteadontheviewthatsystemicallycrucialmarket-makingservicesofferedbybankscouldsuddenlybe impairedwhenabanksuffers large losseson itsconventionallending. (Thecurrentsituation intheEurozone includes thisrisk.) Thisargument isinmyview trumpedbythepotentialsystemic riskposedby themigrationofmarketmakingoutsideoftheregulatedbankingenvironment.

A TechnicalAnnexFigure 11, based on the samemarketmaking inventorydata for a single equity shown inFigure1, illustratesthefactthatunexpectedshocksto inventoryarefattailed,meaningthattherearetheinventorysometimesincreasesordropsdramatically.

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q qq q q

qqqqqqqqqq

qqqqqqqqqq

qqqqqqqqqq

qqqqqqqqqqqqqqq

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qq

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