Wednesday, October 12, 2011

A Tale of Two Regulatory Regimes

     One of these things is not like the other. In a tale of global regulatory disharmony, European regulators say they are going to crack down on high frequency trading, perhaps by forcing perpetrators to become de facto market makers, according to today's FT. They are concerned that HFT algorithms can remove liquidity when trading conditions go against them or are too volatile to read - as happened on the May 6th Flash Crash.
     Fair enough. But forcing HFTs and banks to be market makers in each and every instrument they trade is begging for trouble. It would require a huge amount of additional capital, an issue banks are already whining about. And it flies directly in the face of the U.S. Volcker Rule, the guidelines for which have just been laid out. Specifically, no bank should end up with a long or short position while performing market maker or hedging duties for customers.
     U.S. banks are already confused about the distinction between proprietary trading and taking the other side of a customer's trade, along with the risk exposure that it creates. If they sense that regulators will knock heads every time a client-related position is not fully hedged, they might just move their business elsewhere. This is exactly the regulatory arbitrage that Wall Street was worried about, because it could cost them a lot of business. NYC traders will be polishing up their EU passports.

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