Volcker Rule Threatens Street’s Support of Corporate Bonds and Swaps

“The distinction isn’t always clear, and with the penalties for getting it wrong so severe, our concern is that capital will be withdrawn from the corporate bond market and the issuance of our debt, which ultimately supports our financing,” said Mr. Deas, who currently chairs the International Group of Treasury Associations and recently rotated out of the chairmanship for the National Association of Corporate Treasurers.

indirect impact

Approved by the regulators December 10, the Volcker Rule doesn’t impact nonfinancial corporates directly. However, they may soon find waning enthusiasm by underwriters to participate in their bond offerings and as counterparties in swap transactions, less market-maker support for the securities and derivatives they issue, and consequently higher costs to pursue their financing and hedging activities.

Officially called “Prohibitions and Restrictions on Proprietary Trading and Certain Interests, and Relationships with, Hedge Funds and Private Equity Funds,” the rule was first proposed three years ago and turned out to be less severe than many feared. The rule prohibits banking institutions from engaging in proprietary trading or investing in certain types of typically highly leveraged funds, including hedge funds, but it exempts certain related activities that enable banks’ clients to generate capital, such as market making and underwriting. To do so, however, banks must develop operationally challenging compliance regimes that may discourage at least some from participating in those markets.

In the case of market making, one of several data metrics a bank must provide to regulators to demonstrate it remains in compliance is that its level of market making for a financial product stems from customer demand. Although regulators significantly reduced the number of metrics banks must compute, doing the calculations presents both an initial and ongoing operational burden. In addition, banks must hire additional compliance staff, independently test their compliance policies and procedures, and CEOs must certify that the system is up to snuff.

Hardy Callcott, a partner at Sidley Austin LLP, said the exemption requirements create a barrier to enter the market making business, likely splitting current bank participants into two tiers. The big Wall Street firms such as Goldman Sachs and J.P. Morgan that are under bank holdings companies and sizable brokers like Jefferies and Cantor Fitzgerald will comprise one tier, with regional and foreign banks making up the another.

“The first tier will have the scale to justify setting up the compliance infrastructure, while members of the second tier will probably withdraw from market making, or make markets in a very limited class of securities,” Mr. Callcott said. He added that the same dynamics will likely occur in the over-the-counter derivatives space, where market makers become essential when corporates want to unwind a position.

Such a scenario points to less liquidity in those markets. It may also limit the selection of underwriters. Corporates often distribute underwriting business among a variety of banks, including regional and foreign banks they may use for other services. FMC Corp., for example, used top names as book-running managers—BofA Merrill Lynch, Citigroup and HSBC—and the other 16 underwriters on the offering included regional and foreign banks such as US Bancorp, BB&T Capital Markets, ANZ Securities and Lloyds Securities.

Handing lucrative underwriting assignments to lesser players may become problematic if they’ve bowed out of the market-making business. “You typically have to be a market maker to be an underwriter, because companies want underwriters who are committed to supporting the securities,” Mr. Callcott said.

guestimating impact

Attorneys are still pouring over the 1000-page Volcker document, and so it remains unclear how severe its requirements will actually be in practice. Should a number of banking institutions decrease their market making activities, however, corporates could see financial services and the institutions offering them change significantly.

“Typically two things happen in such a scenario,” said David Robertson, who heads up the financial services practice of Treasury Strategies. “Either there are fewer services for corporate treasurers, or these activities will move outside banks to unregulated entities.”

Another area of concern is restrictions on banks’ hedges. The rule eased the Volcker proposal’s requirements for banks to hedge market-making positions at the trade level. However, restrictions on hedges at the portfolio level, aimed at reducing losses such as those stemming from J.P. Morgan’s London Whale trade, remain significant.

Those restrictions, Mr. Deas said, could ultimately raise hedging costs for corporates. For example, a bank making markets in interest-rate derivatives is likely to hedge its portfolio over the course of a day, rather than one exposure at a time, and its bid to provide a corporate with a position will be based on that portfolio approach. If it cannot hedge its overall portfolio, then the bank must quote a price it is certain it can cover when it matches the trade.

“If there has to be matching going on instead of a portfolio hedging approach, then that will mostly likely raise the cost for corporate hedgers,” Mr. Deas said. In addition, he said, a US-based multinational that hedges a series of exposures worldwide, and in the past has sought to concentrate those exposures through intercompany transactions in a treasury center located at its US headquarters, may decide to drastically alter its hedging strategy. “It may find it more cost effective for its foreign subsidiaries to hedge those exposures with foreign banks, which would not be subject to the Volcker Rule,” Mr. Deas said.

The Volcker Rule will also impact specific financial markets differently, and therefore affect issuers to varying degrees. Mr. Callcott noted, for example, that residential mortgage-backed securities issued without government guarantees will be subject to the rule’s limitations while those carrying the guarantee will not, putting lenders and other players in the “private label” mortgage market at a disadvantage.

In addition, the rule imposes severe restrictions on bank investments in and interactions with funds covered by the rule. Collateralized loan obligations (CLOs), an important source of capital in the commercial loan market, have been exempted from the rule, but most other asset-based securities (ABS) are not.

progressive impact

The Volcker Rule’s impact increases as transactions become more structured and/or less liquid, likely increasing the hurdles for companies securitizing the revenue streams of more exotic assets, such as solar panels or films. The requirements to make markets in those less liquid bonds become harder to meet, reducing banks’ willingness to support them and raising costs for issuers.

In addition, said a former director at the SEC who worked on the rule, it confines banks to underwriting no more than they can reasonably expect in terms of customer demand and requires them to provide data to back up their assertions.

The former director noted that structured products are often highly customized, complicating brokers’ ability to ascertain customer demand for the bonds and potentially putting banks in jeopardy of violating the rule. That means they’ll likely be wary about underwriting issuers’ less liquid, riskier bonds under the assumption they’ll be able to sell them at a profit at some indefinite point when the market turns. “You can’t compare them to other structured products, which would give a basis for determining near-term demand, because they may be structured very differently,” the source said.

In addition, the Volcker Rule’s restrictions on a bank’s ownership in funds subject to the rule could present issuers with complications. New structured transactions will be structured with the Volcker Rule’s provisions in mind, but existing deals may see their liquidity drop as banks back away from them as potential investments because the securities may contain features suggesting ownership. “Banks subject to the Volcker rule will be less inclined to purchase those securities, for fear they would be viewed as acquiring an ownership interest in covered funds, which they’re not allowed to do under the rule,” said the former SEC official, who now works at a major law firm.

Banks almost certainly will be poring over their existing books of business to see if they contain fund assets covered by the Volcker Rule and if the bank has an equity or partnership interest, or “other similar interests” such as other economic measures or the ability to change investment advisors.

“The thing to remember about how the rule affects these transactions… They’re not directly regulating the deals but what banks can do in relation to the securities or in some instances the issuers themselves,” said the attorney. “So the impact on the transactions is really a question of whether the universe of folks that can invest in these securities has shrunk and if that affects their liquidity and value.”