Volcker Rule and Muni-Bond Liquidity–back of the envelope opinion.

Volcker Rule and Muni-Bond Liquidity–back of the envelope opinion.

November 22, 2011 Research Insights
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(Last Updated On: January 23, 2017)

Volcker Rule May Adversely Impact Munis


The municipal bond market makers are making the case that eliminating prop desks will somehow decrease liquidity and screw up the market in municipal bonds.


We love to rake our customers over the coals and take advantage of the fact we get to send liquidity information over to our prop desk. We also love the ability to make money off our cheap access to capital that is backstopped by the American Taxpayer.

The theoretical literature on the subject of bid/ask spreads suggest that the following 3 factors come into play:

  1. dealer order processing costs–the cost of doing business for the market maker
    • this is cheap and will continue to get cheaper as technology improves
  2. dealer inventory costs–dealers have to manage inventory and risk–market makers across many markets seem to do this without a problem.
    • This cost will remain
  3. Adverse information costs–trading is tough when both the buyers and the sellers feel like they are getting f&^#ed.
    • In my mind, this costs would go down a lot if the Volcker Rule were put in place. Having explored the muni market and gotten a taste for how it works–OTC, no transparency, constant fear of prop desk trading, etc.–I am pretty certain that liquidity could actually INCREASE in muni markets if the Volcker Rule were enacted.

On net, the Volcker Rule would simply lower bank profits in the Muni-Market prop game (no more raping customer order flow), but the rule would probably increase transparency and liquidity (customers can worry less about getting raped by prop desk and think more about trading). Overall, the markets and society would be better off. I think.

Regardless, with a ton of lobby power, I’m quite confident that Wall Street banks will continue to be ‘closet hedge funds’ at the detriment of society for a long time.

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Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.