The great debate over the Volcker Rule continues, with news from Bloomberg that Goldman Sachs and Morgan Stanley have submitted comments to regulators that reiterate the basic arguments against the rule.

At the heart of the matter is whether proprietary trading can be separated in practice from legitimate market making and hedging, both of which the rule allows in principle. Is it feasible to come up with a set of rules that can distinguish in all cases liquid markets like the cash equities markets and less liquid markets for various bonds and derivatives? Wall Street execs say it will be hard.

The new rule basically requires that companies make their revenue from commissions, fees and spreads, which might work in some markets, though it's unclear how this will be tracked at the system level. In less liquid markets, however, market making may well require holding inventory over time, which means price changes come into play. Historically, market makers have tried to benefit from holdings as well as spreads and commissions, though that has long generated suspicions. Some would argue that you can't be a market maker if you aren't taking some inventory risk.

Two senators, Carl Levin of Michigan and Jeff Merkley of Oregon, are unpersuaded by the view of the top banks.

"If a firm is holding onto a position in a way that principally profits from price changes in the instrument and it is being held for a period that indicates the holding was not a long-term investment or the extension of credit, then that should be considered prohibited proprietary trading," the senators wrote.

The banks argue that if you apply that rigidly then market making services will inevitably get watered down a bit, forcing clients to hold more risk. It will be interesting to see how the regulators respond. As for banks, there are two countervailing forces at work. On the one hand, market making would become less profitable. But agency-oriented trading will become more profitable.  

For more:
- here's a Bloomberg article

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