NEW YORK ( TheStreet) -- Goldman Sachs ( GS) and Morgan Stanley ( MS) could see their fixed income revenues and profits shrink significantly, if the
draft proposal of the Volcker Rules are implemented, according to Bernstein analyst Brad Hintz. "If the current draft rules are implemented Bernstein estimates the effective prohibition of flow trading in non-exempt market making books would reduce revenues by twenty five percent and cut the pre tax margin of fixed income by one third," Hintz says. "This would bring the pre tax margin of Wall Street's fixed income units from approximately 25% to 18%." The rules are problematic for fixed income trading units because, unlike equity, where the highly profitable investment banking offsets the more costly equities trading and execution business, the core source of profits for the business in in market making. Fixed income contributes 35% of the revenues at Goldman Sachs and 18% of revenues at Morgan Stanley As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act -- signed into law by President Obama last July -- the Volcker Rule prohibits bank holding companies from engaging in most forms of proprietary trading while severely limiting banks' investments in private equity funds and hedge funds. The rule was proposed by the president and supported by former Federal Reserve Chairman Paul Volcker. While most banks have already shut down or spun off their "prop" trading desks in anticipation of the rule, the impact of the rules on market-making, a key function of broker-dealers, has been uncertain. Banks have argued that limitations on market-making will disrupt liquidity in markets. Based on a 205-page draft proposal that was leaked last week, however, it appears that the proposal may have limitations on market-making as well, which could be "very negative" for fixed income trading, according to Bernstein. "The draft document adopts a micromanagement approach in defining what constitutes market making and what constitutes proprietary trading," Hintz wrote. "On one hand, the prohibition on proprietary trading is sweeping; any principal trading not specifically excepted under the law (such as trading in US governments, stabilization of an underwriting transaction or true hedging) is a prohibited proprietary activity. Meanwhile, permitted "market making" activities of a trading unit are narrowly defined," he said. A key surprise of the document, Hintz says, is that it appears to ban "flow trading" in nonexempt portions of the fixed income trading business. Currently traders are able to amass inventory ahead of demand. The proposed rules make it clear that inventory levels must be based on client demand and not on expectation of future price appreciation. --Written by Shanthi Bharatwaj in New York >To contact the writer of this article, click here: Shanthi Bharatwaj.
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