As you might guess, traders want to be paid based on the performance of their portfolio as well. So they have the following criticism, reported by Cheyenne Hopkins and Phil Mattingly at Bloomberg:
A forced change to pay structure "could have the effect of driving people out of the regulated industry to the unregulated industry," said Douglas Landy, a partner at Allen & Overy LLP who once worked at the Federal Reserve Bank of New York.
The logic here is simple enough: if regulation is ramped up in one subsector, then business will flee to a different subsector where it can escape the new regulation. Naturally, market participants will seek the path of least resistance.
But It Doesn't Hold Up
Here's the thing: it isn't really that simple. First of all, there aren't really any truly unregulated sectors. There are some that are less regulated than others. But no subsector within finance is completely devoid of regulation. If hedge funds suddenly become the industry's market makers, for example, then that sector's regulators will take note.
If the market making business that flows into hedge funds poses some new systemic risk, then regulators will need to ramp up regulation in this industry accordingly. But such a move may not be necessary. Hedge funds tend not to be quite as systemically relevant as the big banks -- but that could change over the years if a couple of funds become very gigantic.
So regulators can just keep chasing the business until there's no under-regulated sectors for it to flee to. The financial industry is finite. But this chase might not be necessary. The Volcker and capital requirements are in place at banks for a reason: because regulators say that banks need to be relatively low-risk institutions for the sake of the financial system. So even if business does flee elsewhere, that might be perfectly okay -- the regulation's purpose was still fulfilled.
What the Fear Should Be
In the case of the Volcker Rule's limits on trading, the real fear should be business fleeing overseas. Other nations have not signed onto the Volcker Rule. So if banks are better market makers, then we'll begin to see trading activity growth in markets like Singapore or elsewhere. Firms won't bother looking for an inferior less regulated sector in the U.S. if it they simply find a less regulated banking sector in a market overseas. The global financial landscape makes such a transition relatively easy.
In the case of Basel III, however, there isn't much of a downside to where business might flee. The core business of banks will mostly likely remain at banks. After all, they're the ones with banking expertise. What you'll probably see happen under Basel III is that big banks begin losing a little bit of their competitive advantage over smaller banks, due to its forcing big banks to hold more capital. I would argue that leveling the playing field is a good thing. But since the Basel III rules are internationally coordinated, it doesn't run into the problem the Volcker Rule creates. Essential banking services will just become more expensive.