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A professor's prescient guidebook for financial regulators

Years before the Volcker rule entered the regulatory lexicon, Professor William Silber at NYU was thinking about the Volcker rule.

To explain: The Volcker rule requires regulators to suss out speculative trading, in which banks are making bets with their own money purely to benefit their bottom lines. The difficulty for regulators is that market-makers also trade using the bank's money but to take the opposite side of a trade for their clients.

The distinction here is motive -- a bank's profit versus expediency for customers. But how can anyone tell the difference from the outside? I mentioned Silber in my story on the Volcker rule last weekend. The paper he wrote in 2003, called "The Nature of Trading: Do Speculators Leave Footprints?" could be a guidebook for anyone tasked with enforcing the Volcker rule.

Why was he already thinking about this years ago?

Silber became interested in part because companies acquiring firms that included trading desks wanted to know whether those traders were speculators or market-makers -- and thus how much risk they were taking on.

As he writes:

Understanding and verifying trader behavior is important, because leveraged trading firms and individual traders have traditional incentives to mask their risk taking activities (see Jensen and Meckling [1976]). Without proper monitoring, traders can substitute risky speculation for less risky market-making to reap potential payoffs.

Looking at a bank's balance sheet alone won't tell you much. But Silber points out in his paper that a trader's record can be very revealing. Market makers make their money buying a stock at a certain price and then turning around and selling it for slightly more at a premium for clients who want their trades done immediately -- that difference in price is the bid-ask spread. A true market-maker doesn't worry about whether the stock is priced correctly.

A speculator, on the other hand, is focused squarely on mispricings in the market. If a speculator senses that a stock's price is not right, the trader is likely to pay a slight premium -- the price the market maker is offering -- to get the deal done quickly, just in case the market catches up to the trader's hunch.

A regulator could look, then, to see if a trader is consistently paying that premium, the market maker's offer price, which they can find out by looking at the prevailing prices in the market at the time of the trade. If the trader is consistently paying the market maker's offer price, then that trader is more likely to be a speculator.

By Jia Lynn Yang  |  August 17, 2010; 3:11 PM ET
Categories:  Financial regulation  
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Hire Bernie Madoff as a consultant-seriously.

Posted by: MichaelLittleBig | August 17, 2010 8:57 PM | Report abuse

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