President Donald Trump has consistently talked about deregulating the banking industry since his days as a candidate. Now some of those rule changes are coming into focus. According to a report from Bloomberg News, the so-called Volcker Rule could be in line for a revamp. This could have profound effects on bond market trading and perhaps bank earnings.
Here is what to watch for as details about the rule changes start coming out.
Why Does the Volcker Rule Matter for Bonds?
The Volcker Rule basically states that banks can't do speculative trades in their own name. For bonds, that has had the effect of chilling market-making activity. Remember that bonds are entirely an over-the-counter market. There is no centralized quote system, no exchange. Virtually all trading happens from person to person. Even "electronic trading" is really just a way of organizing the communication between customers and Wall Street banks. In other words, if you want to sell a bond, Wall Street has to commit capital to buy it, and then find another investor to sell it to.
Obviously, the bank buying a bond from me thinks they can sell it later for a higher price, otherwise they wouldn't be able to make any money. The Volcker Rule was supposed to ban speculative trading, but what defines a "speculative" trade?
A trader buying bonds from me doesn't know for sure if he or she wo;; be able to sell it later for a higher price. Is that speculative? Eventually regulators wound up writing a series of complicated rules for determining what constituted a speculative trade and what didn't, but by then Wall Street trading desks had slashed headcount as well as capital allocated to fixed income market-making.
Fixed-Income Market-Making Post-Volcker
Not surprisingly, the fixed-income market has plunged after these regulations were introduced. In 2006, the primary dealers, which includes most of the big Wall Street brokerages, had corporate bonds on their balance sheet equal to over 12 days' worth of corporate bond trading volume. Now that is about 0.6 days. Or put another way, corporate bonds outstanding has almost doubled since 2006, but positions held by banks is down by more than 90%.
This isn't entirely about Volcker. Wall Street obviously went through a reckoning in 2008, and all the banks were trying to keep their balance sheet less leveraged. Traditionally Fixed Income Trading (FIT) has been a low return-on-asset, highly leveraged department, so it is not surprising it was a place banks looked to cut capital allocation. In addition, very low interest rates meant that banks weren't earning as much on positions held overnight (or longer), incentivizing them to only do transactions where they knew they could buy and sell quickly.
Buying and selling quickly also helped with Volcker compliance: if you bought from one customer and immediately sold to another with only a small profit build in, that's obviously a market-making trade.
While time will tell exactly which effects are more important for the bond market liquidity, rising interest rates and more stability in capital requirements hasn't brought fixed income trading back. While Primary Dealers' holding rebounded slightly in 2017, it remains at exactly the same ratio to bonds outstanding and/or trading volume.
Impact on the Overall Market
It has three major effects, both of which should matter for how you think about your portfolio. First, bond trading has become extremely concentrated in a few issues. This makes sense if you think about the fact that banks are incentivized to buy quickly from one customer and sell to another almost instantly. You've probably heard the trading saying that "liquidity begets liquidity."
In the bond market that has meant that the very large issuers that everyone owns trade a lot. These are the bonds that Wall Street is confident that they can quickly find both a buyer and a seller at a pretty well-known price level. For anything that doesn't trade as frequently, which is basically everything but government bonds and maybe the 100 largest corporate bond issues, trading has become very spotty.
The second impact is that Wall Street doesn't want to do big trades anymore. In 2005, if you called Goldman Sachs and wanted to do a $10 million trade, they'd tell you to call back when you had $25 or $50 million to do. Today if you call up and want to do $10 million, they'll probably tell you they will start with $3 million and then we'll talk about where we go from there. If you really want to get the whole $10 million done, or if the bond you own is a relatively unknown issue, they will usually only be willing to "work" the bonds. This means they won't actually buy them, but they will call their customers on your behalf and see if they can generate interest. Notice though that since you still own the bonds, you are taking all the risk. They are hoping to make a few basis points just for making some phone calls.
Lastly, street traders won't step in to arrest a downward spiral on a bond. If a particular name has volatility, Wall Street used to try to figure out what the right value was, buy it a little below that value, and then wait for the smoke to clear. That kind of trading looks much more like "speculative" trading that Volcker bans.
Hence now Wall Street doesn't step in at all until the buy-side shows where they are willing to buy. As a result, the "gap risk," or the chance that a bond suddenly drops by 5 or 10 points has gone way up. As an example, during the energy rout in 2015-2016, there were certainly bonds that were legitimately distressed. However, there were many issuers that weren't. Certainly low oil prices would hurt profitability, but in many cases, they didn't pose any serious threat to their solvency. And yet many of those same issues traded down 20+ points. I'm confident that same thing wouldn't have happened in the pre-Volcker world.
Are We Better Off Scrapping Volcker?
Volcker isn't going to get scrapped. While people in the fixed income markets widely expect some reforms, the core ban on proprietary speculative trading will likely remain. The question is whether it is watered down so much that it doesn't matter? Or will these reforms be more incremental? We shall see.
Selfishly, this new world is more volatile, but it also creates more opportunities for professional bond investors. Basically, the extra money Wall Street used to make off volatility events by leaning against them is now given over to buy-side investors like me. We made quite a bit buying those same non-distressed energy bonds in 2016.
However, for broader market stability, it would probably be better if Volcker were reformed. Making a more expansive view of what constitutes market-making would make the bond market less volatile, especially in already less liquid sectors like municipals, asset-backed securities, etc.
Already fixed income trading has started to make something of a comeback for bank earnings. Goldman's Fixed Income unit's revenue was up 23% year-over-year, and has been touting new hiring in that unit. However, for most banks, any recent rebound in FIT profitability probably has more to do with just earning more interest from higher rates. If bank holdings were to expand, it could re-emerge as a major profit center for banks.
The Wall Street traders I talk to aren't expecting that. They are expecting some relief, and thus some positive effect on both bank earnings and bond market liquidity. However, they are not expecting a return to 2005-levels of liquidity. At its core, this new fixed income world is here to stay.
Tom Graff is a regular contributor to Real Money Pro. Click here to learn about this dynamic market information service for active traders and to receive daily columns like this from Tom Graff, Paul Price, Bret Jensen and others.
