The trend in gold and controversy over the Volcker Rule...

Samantha Casale & Erica Spada, 2/16/12

Gold has been the subject of much debate among financiers, politicians, and households alike over the past few years. Historically, gold has been used as a medium of exchange and a store of value. Today, gold is thought of as a safety net from global political and economic uncertainty. The pro-gold side of the argument says that investing in gold is a risk-free way to store your assets, provides a hedge against unstable sovereign currencies (especially at risk currently in the U.S., with concerns of unsustainable fiscal debt and numerous quantitative easing rounds), and a hedge against uncertain global economic conditions (if all as fails, gold will always be accepted as a means of payment). SeekingAlpha.com

Alternatively, the other side of the argument says that gold is not a risk-free investment because the price of gold in reality is very volatile; it has also been argued that gold does not provide a hedge against inflation, and actually moves with currency inflation. (The Economist) Other arguments against investing in gold state that it’s an unproductive long-term investment (in terms of realised profit), and that gold itself has no intrinsic value therefore its price is at the mercy of the population’s attitudes. (WSJ Blog)

On February 15, 2012 gold futures for April delivery closed at $1728.10 per ounce; an increase of 0.6% which put an end to a three day losing streak. The SPDR Gold Trust grew by 0.27%; Gold mining shares in Barrick Gold gained 0.15%, and Yamana Gold gained 0.55%. Recently there have been several large transactions made by notable investors in the gold market: John Paulson sold 2.9 million shares of SPDR Gold (but is still the largest holder with 17.3 million total), and JP Morgan sold 6.1 million shares of its holdings in SPDR and iShares Gold Trust. While George Soros purchased 37,100 more shares in SPDR, and Bank of America purchased 8.3 million shares in SPDR and iShares Gold Trust. (Gold Breaks Three Day Losing Streak)

Central Banks throughout the world have been purchasing huge amounts of gold lately, with much of this demand coming from emerging economies in Asia and Latin America. In 2011 the amount of gold purchased by Central Banks was the highest it’s been in 40 years (since the collapse of the Bretton Woods system). (Financial Times ; WSJ )

On an interesting side note, yesterday someone wrote an article that links the current decrease in gold prices (over the past two weeks) to the financial sanctions that have recently been implemented by Western countries against Iran. As a result of these sanctions, Iran has turned to some unconventional trade strategies. Iran imports the majority of their food; they have recently been buying wheat, rice, and palm oil from Asian suppliers, and paying for it with gold or oil. The gold that these Asian suppliers have been receiving is immediately dumped into the market (as the suppliers need gold’s cash value to cover their production expenditures). This flood of gold into the market could explain the 2.3% decline in gold prices over the past two weeks. SeekingAlpha.com

The Volcker Rule
Why has the so-called “Volcker Rule” caused such a strong reaction among banks and even non-financial firms? This past Monday, in a deadline before finalization, the SEC, Federal Reserve Bank, and other regulatory bodies received in inflow of letters commenting on the rule and it’s potential consequences. The controversial law, which runs nearly 300 pages long, is another step toward the increased regulation of American banking institutions following the government bailouts during the financial crisis. With the 2010 Dodd-Frank Act, legislators have created roughly 240 new rules and commissioned 70 studies to create a more transparent, less risky financial system.

Section 619 of the act, pioneered by former Federal Reserve Chairman Paul Volcker, prohibits federally insured banks from engaging in any kind of speculative activity. Both proprietary trading and investment in hedge or private equity funds is banned. Most of the banks have already closed their proprietary trading arms, but the banks are now warning that the strict rule against speculative trading will damage their revenue structure and possibly effect the competitiveness of America’s economy.

The rationale behind the Volcker Rule, broadly, is to decrease risk-taking in large financial firms that loom large in the American economy. It lays out the “permitted” banking activities that include market-making, hedging, customer facilitation, underwriting, and the trading of government securities. The ban against proprietary trading, however, isn’t so black and white.

Market-making
The function of market-making is a substantial source of revenue for investment banks. They broker trades on behalf of institutional investors such as mutual and hedge funds, matching buyers and sellers in the market. In practice, though, market-making often involves traders buying large volumes of securities and holding them. If they don’t have an immediate customer transaction, this falls under propriety trading because the bank is holding a position on a stock. More so, market-makers may buy or sell a larger volume than their client ordered because they see a good price opportunity and anticipate future customer requests.

Impact
Various consulting firms have conducted studies on the impact of the rule and agree that it will be costly. A report from Deloitte Consulting concludes that the rule will require significant IT and compliance investment, especially because the fine line between prop trading and market-making is hard to find, and new metrics for monitoring trading will need to be developed. Though this will pose a significant cost for banks, any new regulation requires expenditure. This alone isn’t a reason to lessen the strength of the legislation, but it will most likely push up transaction costs for customers and borrowing costs for companies.

"... [The Volcker Rule] would have serious, adverse effects on our ability to manage our risks and address the needs of our clients, and on market liquidity and economic growth," a letter on behalf of JP Morgan stated.

One of the arguments the banks have used in criticizing the law is that the ban on speculative trading will reduce market liquidity. They argue that they will no longer be able to provide the fast transactions that their clients might require. This effect is hard to quantify, however. Additionally, some banks warn that the rule will hinder American economic growth by forcing market participants to move their trading activity outside of the U.S. This is not a certainty. Many economists counter this, holding that the structure of the market will probably change and allow other American non-banks to enter.

Deloitte's report

Bloomberg: Harsh Critics


Bloomberg (Video): Volcker Rule will increase costs


Financial Times: Brighter Side of Volcker