The market-maker problem | FT Alphaville

The market-maker problem

Reuters uber-columnist John Kemp has penned some thoughts about the ‘Volcker rule’, and according to him the biggest problem facing the implementation of the prop trading ban will be differentiating internal speculative business from market-making activity.

That’s because there is a blurry line between the two, in part due to the proliferation of algorithmic technology and the practice of banks taking on internal speculative positions, or simply opposite positions, to aid their market-making operations.

As Kemp explains, it will take a lot of nosing aroundwithin institutional practices to determine what’s what. That in itself is likely to be a monster of a job:

MARKET-MAKING FUNCTION The biggest problem will be separately identifying proprietary trading on the banks’ own account from legitimate market-making activities on behalf of customers.

Most banks have separate private equity departments. Some also have dedicated prop trading desks and internal hedge funds. But in many cases prop trading and hedge fund like activities have not been separated out. It will prove hard to identify which securities are being held for strategic “speculation” and which are being held as part of a tactical, liquidity-producing trading book.

In many instances the distinction may not make much sense, and is not how banks organise their operations. Difficulty in implementation is not a reason not to press ahead. Detailed regulations can be drafted later. Enforcing a separation between proprietary trading and market making will require considerable intrusion from regulators (either in the form of rather blunt prohibitions or very intensive supervisory visits and demands for data).

Until now, supervisors have been reluctant to interfere this much in the internal workings of banks. But beefed up regulation is the inevitable condition for taxpayer support, and Obama’s endorsement will stiffen regulators’ resolve in the United States and elsewhere.

In the meantime, because banks’ market-making activities are so thoroughly meshed with their propriatery operations, it’s understandable why the market sees the future for non-bank related market making as currently being peachy in the context.

Related links:
Was 2009 the year of the market maker?
– FT Alphaville
2010: Obama’s year of the market-maker?
– FT Alphaville
Quick View: Who are the Obama-ban winners?
– FT Trading Room