Basel Committee takes a look at market making, prop traders and liquidity provision


Global regulatory authorities have been busily engaged in ascertaining the most effective method of regulating various business-critical activities in electronic trading for approximately four years, ever since President Obama swore the Dodd-Frank Wall Street Reform Act into US law in 2010.

This set a precedent among continental regulators for them to instigate a standardized method of practice, with Europe and Asia following the lead of the US.

This week, the Bank for International Settlements released a report which covers certain policy implications which may affect proprietary trading, a notorious moot point among various regulatory authorities, and market making.

The Bank for International Settlements considers that market-makers serve a crucial role in financial markets by providing liquidity to facilitate market efficiency and functioning. Post crisis, several developments suggest that the behaviour of these liquidity providers may change. Such changes and their potential impact on fixed income markets are of particular interest to policymakers, given the relevance of these markets to monetary policy and financial stability.

Against this background, in September 2013, the Committee on the Global Financial System (CGFS) established a Study Group on market-making and proprietary trading which was chaired by Denis Beau, of the Bank of France, to facilitate a better understanding of how ongoing changes in these activities may affect the provision of immediacy services and, hence, liquidity in fixed income markets.

Whilst bank liquidity and fixed income market making is crucial to all financial markets globally, many FX firms are polarizing their opinions with regard to this methodology, with certain companies operating a strict agency model with no spread mark up whatsoever, and with others gravitating further toward market making by offering fixed spread accounts.

Bearing this in mind, the Bank for International Settlements has concurred that there has been a decline in dealer risk-taking capacity and/or willingness in recent times. One apparent trend is market-makers’ increasing focus on activities requiring less capital and balance sheet capacity. In line with this development, banks in many jurisdictions report allocating less capital to their market-making activities and are reducing their inventories by cutting back on their holdings of, in particular, less liquid assets.

A further subject for inter-governmental discussion is the increasing differentiation and greater focus on core markets. A number of market-makers have reportedly adopted a more selective approach to offering client services (eg focusing on core clients), whereas others are narrowing the scope of their services (eg focusing on a smaller range of markets). In many jurisdictions, market-making has been shifting towards a more order-driven and/or brokerage model. As a result, the execution of large trades tends to require more time, with many market-makers being more reluctant to absorb large positions.

As has been vocally explained by many European regulators, there is a wish for the diminishing of proprietary trading by banks. Proprietary trading has reportedly diminished or assumed more marginal importance for banks in most jurisdictions, particularly in the euro area.

Expectations are for banks’ proprietary trading to generally decline further or to be shifted to less regulated entities in response to regulatory reforms targeting these activities. This contrasts with trends in individual jurisdictions, particularly in Asia, that have been less affected by the recent crisis. This occurred in Europe in such a way that certain non-bank regulators which oversee FX firms have banned high frequency trading, one poignant example being Germany’s BaFIN which spearheaded the movement in that direction in 2012, followed by several EU figures, including EU Commissioner Michel Barnier, to seek to ban high frequency trading.

In North America, things are somewhat different, as the Volcker Rule within the Dodd-Frank Act was invoked last year in order to put a stop to proprietary trading in a nation whose trading desks of Chicago and New York are synonymous with being some of the world’s most active in this methodology. When the rule was finally invoked, it included banks, but FX firms and OTC derivatives trading was exempted, thus giving a green light to algorithms, high frequency trading and proprietary trading for the foreseeable future.

With the expansion in electronic trading across all markets, including within banks, market participants and relevant authorities should help mitigate the risks associated with liquidity illusion by strengthening liquidity risk management as well as by improving market transparency and monitoring. With the cumulative effects of the newly emerging regulatory environment and other structural changes still uncertain, policymakers may also want to keep track of their combined impact on the effectiveness and robustness of market-making arrangements.

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Market-making institutions and their supervisors should ensure that improvements to shock absorption capacities brought about by ongoing regulatory reforms are effective in stressed liquidity conditions, for example via dedicated liquidity stress tests devised for that purpose.

In terms of possible backstops, regular liquidity-providing activities are likely to remain central banks’ main line of defence. Establishing or expanding securities lending facilities could be considered as an additional option to improve, as needed, market liquidity in key markets during times of stress and to support the robustness of the associated repo markets. Considering other, more direct measures to support market functioning involves several difficult cost-benefit trade-offs (eg due to the risk of distorting economic incentives for market participants). These would need to be taken into account by policymakers if they were to consider whether and under what conditions they might be prepared to adjust existing backstops in the future.

Another factor affecting quotes at the individual dealer level is the difference between the current and the desired inventory. The latter reflects current and expected customer order flows as well as limits imposed by the dealer’s risk management framework, eg those based on value-at-risk (VaR) and other metrics. Dealers whose positions approach the limits set by their institution’s risk management framework are thus incentivised to adjust their quotes to realign their inventory.

Reduced tolerance for risk at the firm level will impact the amount of capital dedicated to market-making activities. This is likely to affect less liquid markets most, as these typically require market-makers to warehouse securities for longer periods of time with fewer hedging options, driving up inventory risks, it is also likely to affect brokerages which operate on a profit and loss model, as depicted by the chart below.

Capture 1

It is a long, laborious road to regulatory reform, however most certainly, times are changing.

For the full report from Bank for International Settlements, click here.

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Basel Committee takes a look at market making, prop traders and liquidity provision

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