Don’t Mix Volcker Rule, ETFs

By Ugo Egbunike,

Shutterstock photo

As the Volcker rule's July 21 implementation date draws nearer, financial giants such as Goldman Sachs and Bank of America have come out with a list of concerns about the rule.

The rule puts critical revenue sources for banks on the line, so it's hardly a surprise they're concerned. To cut to the chase, their reservations about how the rule could affect ETF market making are quite valid.

Under the rule, commercial banks and institutions that own banks will be banned from proprietary trading. The thought behind rule is to prohibit banks from taking on bets with clients' deposits.

However, if applied to ETF market making, major players such as Goldman, Citibank and JP Morgan would be heavily restrained in their market-making activities. The core issue here is how do you distinguish between pure market making and proprietary trading?

In the case of ETF market making, trying to determine the intent behind trades is incredibly impractical.

An authorized participant making a market in SPY, the SPDR S'amp;P 500 ETF (NYSEArca:SPY) isn't simply doing that, but also trading in the underlying markets to establish a hedge. And that's not the whole story. APs can use a wide array of securities, such as futures, to offset their exposure.

Under the Volcker rule, what kind of omniscient system would have to be set up to ensure that a trader bought Exxon Mobil simply to offset a portion of exposure to,  say, XLE, the Energy Select Sector SPDR Fund (NYSEArca:XLE), and not for the "evil" purposes of "prop" trading? Beats me.

ETF market making is even more complex when dealing with fixed-income and international ETFs. In those cases, APs don't have all the underlying securities in an ETF to offset their exposure, and end up using a vast array of baskets, or other securities, to ensure that they're as hedged as they can possibly be.

The beauty is that the different hedging and market-making methods allow for investors to receive executions that are more representative of the ETF's fair value.

The use of various hedging strategies is a key component to the competitive nature of ETF market making, and that competitive landscape will most assuredly take a hit if the Volcker Rule elbows its way in the world ETF market making.

If Goldman or B of A ever shut their "delta-one" desk operations, major trading firms such as Knight and Susquehanna would still dominate ETF market making. But a crucial element of competition would diminish.

The loss of competition wouldn't only affect investors on the buy-side; it would also affect ETF issuers.

Fewer APs in the marketplace would mean fewer parties willing to seed new ETFs. Say what you will about the proliferation of ETFs, but seed capital is still essential to the growth and innovation of this industry. This concern is so crucial that even NYSE Euronext has weighed in and argued the Volcker Rule shouldn't be applied to ETFs. It's no secret the rule would directly affect liquidity.

I understand the intent behind pushing such a piece of regulation, but really the effort is misguided.

Senator Spencer Bachus (R-AL) is right to say that "asking regulators to determine motive and intent …. is tremendously difficult."

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing ETFs
Referenced Stocks: SPY , XLE

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