The 2012 Regulatory and Market Landscape

From: WSJ

‘Volcker Rule’

Boon or Bane? It Depends Which Side of Street You’re On

Depending on whom you ask, the so-called Volcker rule will mean either the end of banking as we know it or toothlessly allow banks to continue to bet the house—with the backing of the U.S. taxpayer. Neither of these extremes are true, of course.

The Volcker rule, part of the landmark 2010 Dodd-Frank financial-overhaul law, will curtail large banks’ proprietary-trading activities. In other words, no more multibillion-dollar bets on whether the housing market will rise or fall or whether the dollar is going to do better (or worse) than the euro or yen.

The Volcker rule isn’t scheduled to be implemented until this July, but it has already had a significant impact on Wall Street. Large banks such as Goldman Sachs Group Inc. and Morgan Stanley have trimmed their proprietary-trading operations. Big U.S. banks could see their annual revenue trimmed to the tune of $2 billion a year because of the Volcker rule, according to analyst estimates.

While the rule could make banks less profitable, supporters argue it will make them less prone to economy-wrecking blowups. And over the long run, bank profits should be more stable.

There are sure to be plenty of unintended consequences of the rule, both good and bad. Bernstein Research analyst Brad Hintz says the Volcker rule could give a leg up to big banks’ competitors. “The spirit of Volcker attempts to limit outsize risk-taking by individual firms, but may effectively narrow the gap between the Street’s best traders and peers,” he wrote in a report.

Critics worry that if the rule is too harsh, it will prevent banks from conducting plain-vanilla market-making operations—the buying and selling of assets on behalf of customers—because those activities often look like proprietary trades. That will make it tougher for ordinary investors and companies to buy and sell securities, they say.

Many questions remain about what the final version of the rule will look like. The latest proposal, at more than 300 pages, showed that regulators drafting it are grappling with a number of issues—including the definition of proprietary trading. If Republicans take control of the federal government after the 2012 election, the rule itself could be at risk. A number of congressional Republicans have vowed to scrap the Dodd-Frank law, which they say imposes too many restrictions on the financial industry.

Four regulators have already weighed in on the rule. The fifth, the Commodity Futures Trading Commission, is expected to vote on a proposal in January.

—Scott Patterson

‘Systemically Important’

Designation Decisions Expected on Threats to Financial System

The minute the Dodd-Frank financial overhaul became law in 2010, one of the hottest parlor games in financial circles became guessing which financial companies would get dragged into the tough, new regulatory system designed for “systemically important” firms.

The designation is reserved for financial firms that regulators believe could threaten financial stability if they run into trouble. The tougher rules include stricter capital, liquidity and leverage requirements than other firms face. While Dodd-Frank automatically puts any bank with at least $50 billion in assets in that camp, it left it up to regulators to decide which, if any, insurers, hedge funds, asset managers or other financial firms that aren’t organized as banks qualify for stricter regulation and supervision by the Federal Reserve.

The Financial Stability Oversight Council, a group of the nation’s top regulators, has made progress on that question and is likely to make its first designations in the coming year. But some analysts believe regulators won’t name firms until late in the year given the controversy surrounding the issue.

The council in October put out a proposed three-stage process and set of criteria—including quantitative thresholds such as asset size and leverage ratio—that will guide its decision making, though regulators retain the ability to designate firms that don’t fit within the guidelines. The council plans to issue a final version before it makes any designations. The period for public comment, which ended in December, gave companies and industry groups another change to deluge the council with letters arguing why they’re not a threat to financial stability.

Analysts widely expect that General Electric Co. unit GE Capital and insurers Prudential Financial Inc. and MetLife Inc. will be labeled systemic; the latter are the two largest U.S. life insurers by assets. American International Group Inc. is also seen as a likely pick because it was the recipient of one of the biggest federal bailouts of the 2008 financial crisis after losses in a financial-products unit almost caused the company to collapse. Some observers say asset managers like BlackRock Inc. also will be tagged.

Meanwhile, big banks are busy writing their so-called living wills, roadmaps they must give to U.S. regulators showing how to liquidate the company if they fail. A number of the largest bank holding companies—those with at least $250 billion in U.S. nonbank assets—must submit their initial plans to the Fed and the Federal Deposit Insurance Corp. by July 1, 2012. Smaller U.S. firms have an additional year or more to draft theirs. Foreign banks have to participate, too, though those with only a small U.S. presence can write less detailed wills. Any nonbank institutions that are designated as systemically important would also have to draft a living will.

—Victoria McGrane


Over-the-Counter Derivatives, MF Global Fallout Top Agenda

The Commodity Futures Trading Commission will continue construction of a new regulatory regime for over-the-counter derivatives in 2012, while also grappling with the fallout from the failure of broker-dealer MF Global Holdings Ltd.

Regulators will continue their investigation into why an estimated $1.2 billion in customer funds went missing before the firm filed for bankruptcy protection Oct. 31 and consider the implications for the mostly self-regulated futures industry. Some traders, lawmakers and regulators have called for major changes, including the creation of an insurance fund that would help investors if their money is stolen by a broker.

The CFTC hasn’t yet taken up the idea, which some worry could make trading more expensive, but it has the support of at least one commissioner, Democrat Bart Chilton, who says it is necessary to instill “confidence and trust back into our U.S. derivatives markets.”

“The MF Global debacle has highlighted some significant problems with how we treat and deal with customer monies,” Mr. Chilton said in a December letter to lawmakers.

While the hunt for the missing MF money continues, the CFTC will also be working on expanding its scope beyond commodities and futures to include the “swaps” market, a previously unregulated corner of the financial markets that played a role in the 2008 financial crisis. The commission is writing new rules to complete the financial-regulatory overhaul Congress put in motion with the Dodd-Frank law in July 2010.

The law instructed regulators to create a new system of oversight for swaps, which are currently traded over the counter rather than on an exchange, aimed at making the market safer and more transparent. Once finished, the CFTC’s new rules will require traders to buy and sell many types of swaps on trading platforms and then route them through clearinghouses that collect money from both sides of the deal and secure the trade if one side defaults.

CFTC Chairman Gary Gensler says his goal is to finish the rules by year’s end.

—Jamila Trindle


Tighter Money-Fund Rules Divide Agency’s Commissioners

When Lehman Brothers collapsed in September 2008, its bankruptcy triggered losses in a money-market fund called the Reserve Fund, sparking a panic in the $2.7 trillion money-market industry.

Three years later, Securities and Exchange Commission Chairman Mary Schapiro remains concerned the money-fund industry is still vulnerable to customer runs in times of panic, despite sweeping changes in 2010 designed to make the industry more resilient. The overhauls included tighter credit-quality standards and a new requirement that funds keep enough cash on hand to meet “reasonably foreseeable redemption requests”—changes designed to prevent funds from “breaking the buck,” or having their price per share drop below $1.

In early 2012, Ms. Schapiro plans to push for additional overhauls that could change the way the industry functions and further reduce already-low returns for shareholders, possibly by requiring the funds to hold bank-like capital buffers to pay investors in a crisis. She says the buffers are needed to fix structural deficiencies that make funds vulnerable to runs if a security has a substantial and unexpected decline in value, which could happen if a fund owns the debt of an entity that collapses.

Such a run in 2008 caused the U.S. to step in with an unprecedented money-fund guarantee, Ms. Schapiro said in a recent statement, adding that is why she hopes to present a proposal to the commission “early in the new year” to address remaining “structural weaknesses.”

To be sure, Ms. Schapiro faces an uphill battle. The money-fund industry and most of her fellow commissioners don’t believe additional overhauls are needed, arguing the 2010 changes ought to be given more time to work. “I don’t think I’ve seen the justification for further changes,” Luis Aguilar, a Democrat who often votes with Ms. Schapiro, said in an interview.

Daniel Gallagher, a new Republican member of the SEC, said in a December speech that a buffer large enough to backstop funds would drain too much capital and kill the industry while a smaller buffer, even one that grows slowly over time, would only create the illusion of safety where none exists.

Mr. Aguilar said he agrees with Mr. Gallagher, and is concerned the capital-buffer idea that Ms. Schapiro has outlined would hamper “small to midsize companies that rely on money funds to meet their payroll, without adding to investor protection.”

But Ms. Schapiro and other SEC staffers remain concerned about the risks to the financial system posed by money funds and don’t want to wait for another panic to act. “Those who forget the past are doomed to relive it,” said one SEC staffer working on the project.

Also on tap for 2012: a legal showdown over stock language in the SEC’s settlements with financial firms that allows them to neither admit nor deny the agency’s findings of wrongdoing. The SEC argues it is unwise to reject proposed settlements simply because a company refuses to admit guilt. But a federal district court judge, Jed Rakoff, believes firms often view settlements of serious allegations for modest penalties, and no admission of wrongdoing, as just a “cost of doing business.” An appellate panel will review the ruling in January.

—Andrew Ackerman


Consumer Watchdog Fights to Claim Its Intended Bite

The six-month-old Consumer Financial Protection Bureau heads into the new year without a leader and its future makeup very much up in the air. The bureau remains particularly contentious among congressional Republicans, who are urging the White House to overhaul the agency’s structure.

But partisan battles in Washington haven’t stopped the watchdog from building up its market-research unit, evaluating consumers’ credit-card gripes, examining the inner workings of some of the nation’s largest banks and laying the groundwork for new consumer-protection rules. And even if the feud keeps it directorless, the agency in 2012 is expected to beef up scrutiny of a crucial consumer-finance product: home loans.

The consumer bureau, a centerpiece of the 2010 Dodd-Frank financial law, has already taken several steps to evaluate home-lending practices more closely. In December, it started addressing and receiving consumers’ mortgage-related complaints, a function that could help alert the agency to any potential lending problems or wrongful foreclosures at a time when banks continue to face probes into fraudulent foreclosure practices.

In addition, the bureau—which has the task of ensuring that financial firms adhere to fair-lending and other consumer-protection rules—intends to keep an eye on the mortgage industry through its new supervision program, launched in July. The bureau in October made clear that its examiners would be closely evaluating banks’ efforts to help troubled borrowers avoid foreclosure.

“Mortgage servicing has a huge impact on consumers and is a priority for the CFPB,” the bureau’s temporary leader, Raj Date, said in October, when the bureau outlined its strategy for examining mortgage companies’ lending practices. “We are going to take a close and measured look at whether servicers are following the law.”

The agency also will continue work on a series of projects designed to help consumers understand the costs and risk of mortgages, student loans and other products. The goal is to streamline the disclosures firms give to consumers in a way that cuts down on fine print and legalese. The bureau will also be conducting research on private student loans, as required by the Dodd-Frank law.

Meanwhile, if the bureau gets its first chief, its focus could quickly shift to payday lenders and thousands of other nonbank companies that offer consumer loans. Overseeing these lenders was supposed to be one of the bureau’s most important duties. But under Dodd-Frank, the agency can’t supervise nonbank firms until it has a permanent director in place.

While President Obama in July nominated ex-Ohio Attorney General Richard Cordray to serve as the bureau’s director, a battle over the nomination has shown no signs of letting up. In December, Senate Republicans, who want the bureau run by a panel instead of a single director, blocked a vote on the nomination.

—Maya Jackson Randall

Mortgage Rules

Regulators Aim to Avoid Repeat of Housing-Market Collapse

Regulators plan to finish two rules next year that aim to prevent a repeat of the dramatic slide in mortgage-lending standards that fed the housing bust and financial crisis.

The Dodd-Frank law mandated that lenders determine that borrowers have the ability to repay the loans they receive. And it charged regulators with creating a basic set of lending standards that the mortgage industry must follow.

Since lenders are unlikely to make loans that don’t meet this ability-to-repay requirement, this first rule could effectively ban lending practices such as interest-only mortgages and loans in which the principal balance can rise.

The new Consumer Financial Protection Bureau is aiming to finish the rule early in the year, working off a proposal drafted by the Federal Reserve in the spring.

Banking groups are pressing for a broad definition of what kind of loans meet this “qualified mortgage” standard and are seeking protections against lawsuits for loans that meet the criteria set out by regulators.

Consumer advocacy groups, however, want to preserve borrowers’ ability to sue lenders and want to ensure that the lending standards aren’t too loose.

In the second rule, Dodd-Frank also required banks that package mortgages and other assets into securities hold a portion of the risk themselves, under the theory that this requirement will discourage risky behavior. However, the law directed regulators to come up with an exemption for high-quality loans.

Regulators’ initial proposal to require down payments of least 20% for these “qualified residential mortgages” has brought criticism from the banking industry, consumer groups and lawmakers on Capitol Hill. They argue that the regulation, as is, will make it too hard for Americans to qualify for mortgages.

Given the huge amount of pressure on the issue, regulators will “probably have to back off,” and impose a down-payment requirement of 10%, said Anthony Sanders, a professor of real-estate finance at George Mason University.

—Alan Zibel

Deals & Deal Makers

M&A Faces a Tough 2012, but Spinoffs Could Do Well

Deal makers aren’t optimistic about the health of mergers-and-acquisitions activity in 2012, given the lingering uncertainty over Europe and the fragile U.S. economic recovery. Some bankers even say the deals market won’t pick up again until 2013. The bulk of deal-making activity will come from global, blue-chip companies that can withstand short-term market volatility and make strategic decisions based on long-term growth, bankers and lawyers predicted.

“Everyone’s on the same wavelength that 2012 is likely to be a very tough year,” said Thierry D’Argent, global head of M&A at Société Générale’s corporate and investment bank in Paris. “It’s difficult to be anything but cautious right now.”

Many deal makers said companies will try to find creative ways to increase value for shareholders, such as spinning off businesses in a tax-free manner. Spinoffs were popular in 2011, and it’s a trend deal makers expect will continue.

The push for spinoffs and breakups in 2011 sometimes came from shareholders, who urged companies to separate low-growth businesses from faster-growing ones so that their holdings could be valued fairly. Shareholder activism is expected to increase this year, with investors pushing companies to merge or sell low-growth businesses in an attempt to improve per-share returns. Deal makers expect this spring’s proxy season to be more contentious than last year’s.

More M&A activity could also come from nontraditional capital sources, such as pension funds and sovereign-wealth funds, said John Studzinski, global head of Blackstone Advisory Partners LP. In 2011, Blackstone advised on the sale of a 30% stake in GDF Suez SA’s oil and gas exploration and production operations to China Investment Corp. for about $4 billion. “The sovereign-wealth funds see fixed assets, like oil, gas, metals and mining, as good, long-term investments,” Mr. Studzinski said.

Such funds could also team up with private-equity firms to pursue deals, a trend that has been in the making for some years but is expected to pick up in 2012 as buyout shops look for additional sources of cash. Last year, some private-equity firms remained on the sidelines of M&A activity, partly hamstrung by the lack of financing. KKR & Co. brought in Japanese trading house Itochu to pitch in cash for its $7.2 billion acquisition of oil and gas explorer Samson Investment Co., while Apax Partners teamed up with two Canadian pension funds to buy wound-care products maker Kinetic Concepts for about $5 billion.

—Anupreeta Das, Gina Chon and Dana Cimilluca


Prospects for a Facebook Offer Brighten a Murky Picture

Initial public offerings were depressed around the world as 2011 drew to a close, but Wall Street appears divided in its prognostications for early 2012.

There are those who believe that fund managers will be more willing to buy IPOs in the new year than they were at the end of 2011, when they were intent on protecting whatever gains they managed to eke out in an up-and-down year in markets.

“I think 2012 is set up to have an incredibly active first quarter because the buy side remains significantly underweight equities now,” said Mark Hantho, global co-head of equity capital markets at Deutsche Bank AG.

Though there are many who share Mr. Hantho’s optimistic view, there are others who are more cautious given the dynamics of a market that is subject to sudden swings. Since so much of market performance appears to be driven by macroeconomic events in Europe that are unlikely to be resolved quickly, some observers say investors should be prepared for more of the same in the months ahead.

“Our view is that the last six months are indeed a precursor to the next six months,” said Mary Ann Deignan, head of Americas equity capital markets at Bank of America Merrill Lynch. “When we come back in January, the issues that investors and bankers are talking about will most likely be the same as now.”

On a regional basis, that means Europe will likely be a dead zone for IPOs; Asia will still dominate issuance, but at a slower pace than it saw in early 2011 and throughout 2010; and the U.S. will continue to see new stocks come in fits and starts, as the market allows.

“The U.S. market appears more resilient from the macro themes that are affecting Europe, but there will continue to be times next year when the negative news flows impact the U.S. market as well,” said Viswas Raghavan, global head of equity capital markets at J.P. Morgan Chase & Co. “But deals are successfully getting done, both in the U.S. and in Asia, and a decent level of activity is likely to continue out of both these regions.”

In particular, there are a couple of high-profile Internet deals waiting in the wings in the U.S. Consumer-reviews website Yelp Inc. has filed to go public in 2012, and social-media giant Facebook Inc. is widely expected to. Investors and private companies will be watching both closely for indications of how they might fare in the wake of online social gaming company Zynga Inc.’s disappointing debut in December.

—Lynn Cowan

Hedge Funds

To Stay or to Go? That Is One Question Investors Face

If 2011 felt like a disaster for some hedge-fund managers, there are likely to be aftershocks coming in 2012.

Hedge-fund performance lagged behind that of stock markets for the third straight year in 2011, giving investors reason to take a fresh look at their portfolios and make adjustments. Those adjustments could come in early 2012 in the form of investors pulling their cash from certain managers and putting the money elsewhere.

“What a miserable year for hedge funds,” said Vidak Radonjic, of Beryl Consulting Group LLC, who advises on hedge-fund investing. He noted that “redemptions might be very heavy in the first quarter of 2012.”

It was just a few months ago that many hedge-fund managers who had significantly performed worse than their peers, particularly those like Paulson & Co., were being highlighted for potential year-end withdrawals. But a rally in October helped stave off the punishment.

Now, in a fresh year, investors will be forced to revisit the question of whether to pull cash—and managers will have a hard time offering a bright outlook given that many of the problems that plagued markets in 2011 remain unsettled.

One prime example: The European sovereign-debt crisis, which drove markets in 2011, seems sent to continue to play out in 2012. The market swings that came as a result of the uncertainty in Europe in the fourth quarter are likely to continue into the new year, managers and investors say.

Managers are also likely to be focused on a ramped-up regulatory environment. In the first quarter of 2012, most managers will be required to register with the Securities and Exchange Commission, if they aren’t already registered. This will give investors—and the public—a better look at hedge funds through public filings.

Steve Nadel, a hedge-fund lawyer with Seward & Kissel LLP in New York, said “registration issues will continue to dominate” the discussion in hedge funds in early 2012, but he also predicted changes that could lead to more taxation of the industry and also greater regulation in the wake of the collapse of commodities brokerage MF Global Holdings Ltd.

Still, while the regulatory climate could be increasingly burdensome, there will likely be a wave of hedge-fund launches in 2012. The thinking among some in the industry is that top talent could see this is a good time to branch out and launch a new fund, as payouts possibly diminished because of weak overall fund performance.

—Steve Eder


Analysts’ Biggest 2012 Concern Isn’t Supply, but Rather Demand

The risk of an economic train wreck in major consuming countries hangs over commodity markets entering 2012, and could undercut prices even for goods currently in short supply and high demand.

Europe’s inability to get its financial house in convincing order hit raw materials hard late last year. And Congress’s failure to strike a far-reaching deal on lower U.S. spending was likely the biggest event of the fourth quarter for commodities, according to Colin Fenton, the chief commodities strategist for J.P. Morgan Chase.

“I am very nervous about the near term,” Mr. Fenton said. The bank cut its commodities outlook to “underweight” late in 2011, not because the world seemed on the brink of discovering vastly more oil or copper but because of concerns about who would be buying what currently exists.

That is one measure of how serious the economic problems are. Swings in commodity prices are often driven by events like miner strikes or crop damage from harsh weather, but analysts are particularly focused on the bigger picture this year. “Unresolved issues surrounding the sovereign-debt crisis and bank deleveraging will remain overhangs,” Morgan Stanley analysts wrote last month. Goldman Sachs sounded a similar note: “The European debt crisis remains a significant downside risk in 2012.”

Political events far beyond the commodity markets could also be critical in the year ahead. The sudden change of leadership in North Korea and recent saber-rattling in Iran both point to threats that could send prices spiraling down or rocketing up.

Still, many analysts take an even broader view in the longer run. Fundamental forces that have driven the commodity rally for years—especially an increasing hunger for raw materials in the rapidly growing developing world—are unlikely to be thrown off for long by anything short of economic Armageddon, they contend.

In Mr. Fenton’s view, emerging changes in the global commodities trade could even help resolve some of the current problems plaguing heavily indebted developed countries and resource-hungry emerging nations. The “essential solution,” according to a recent report by Mr. Fenton, is for China to trade some of its deep reserves of U.S. Treasury debt for abundant supplies of food and growing supplies of energy from North America. Trading Chinese capital for “realistically priced European distressed debt” would also help Europe, the report said.

“Commodities are part of the solution,” Mr. Fenton said in an interview. Financial imbalances between the West and China can be adjusted “using the resources we already have.”

—Liam Pleven


NYSE-Deutsche Börse Tie-Up Hits EU Regulatory Hurdles

The biggest and most politically charged of 2011’s attempted exchange mergers ended the year on a cliffhanger, and investors may have to wait until mid-February to find out whether the New York Stock Exchange will have a new—and foreign-based—parent.

European regulators are scrutinizing the planned marriage of Big Board parent NYSE Euronext and Germany’s Deutsche Börse AG, a tie-up that would create the world’s largest exchange group in terms of listed companies and derivatives contracts traded. The deal struck in February 2011 would create a trading titan domiciled in the Netherlands and poised to partner up with faster-growing markets in Asia.

An estimated €3 billion ($3.9 billion) in trading efficiencies would be welcomed by European banks facing stepped-up capital requirements, and the exchanges tout their combination as giving everyday investors access to a smorgasbord of stocks and financial instruments.

Not so fast, say Brussels’s antitrust enforcers.

Fusing NYSE Euronext’s prized London futures market with Deutsche Börse’s Frankfurt-based derivatives platform matches up plenty of complementary markets, but it also adds up to an estimated 90% of on-exchange futures and options trading in Europe. That point hasn’t been lost on smaller exchange operators, which have encouraged European Union authorities to push for divestitures.

The exchange partners have offered to sell swaths of their European options markets, some trade-processing services and even grant rivals limited access to Deutsche Börse’s clearinghouse, a cornerstone of the deal. In late December, the exchanges offered to cap some trading fees for a three-year period.

All that may not be enough for EU Competition Commissioner Joaquin Almunia, who has voiced reservations about the deal and could yet seek stricter measures. There is a limit to how far the exchanges are willing to be pushed, however: Executives have promised not to sell either exchange group’s futures market in full, saying they would sooner quit the deal.

In the meantime, investors in the companies still aren’t sure what the enlarged company will look like. Nearly a year since the deal was struck only two board members and eight executives have been identified—and no name. Executives on both sides are seen leaning toward a new moniker for the parent while keeping the names of the individual markets, including the storied New York Stock Exchange.

—Jacob Bunge

High-Frequency Traders

Coming-of-Age Story: Rapid-Style Investing Grows Up

The coming year could see high-frequency trading, a quiet business that powers a huge chunk of the market, step out from behind the screens.

First stop: the floor of the New York Stock Exchange, a place that computer traders have historically avoided in favor of smaller and faster share-trading platforms. Three major electronic market-making firms—Getco LLC, Knight Capital Group Inc. and Virtu Financial—have staked out ground at the Big Board to extend their strategies into new corners of financial markets, giving lesser-known names a growing profile on Wall Street.

Software-powered firms elsewhere are adding staff to promote the use of their mathematics- and statistics-fueled trading algorithms among funds and asset managers, while seeking greater influence in market rule-writing.

“It’s not wrong to say that the high-frequency traders are growing up,” said Larry Tabb, founder of the Tabb Group, a research firm that studies the structure of financial markets.

Proprietary-trading groups have mined profits by rapidly buying and selling securities, bonds and derivative contracts in sub-second speeds. They often act as market makers, or traders that maintain steady offers to buy and sell on an exchange. Such firms don’t have customers in the usual sense and often trade using only their own funds.

This is changing as the biggest firms seek to keep growing and competition approaches the saturation point in sectors like the U.S. stock market. Manning a post on the NYSE floor means interacting with share-issuing companies. Selling trading tools means staffing a sales force and maintaining customer relations.

High-speed traders are also keeping closer watch on regulators, currently crafting new rules for commerce in exotic swap deals that could allow private, electronic firms to compete with Wall Street’s biggest banks. There remain separate issues raised by the 2010 “flash crash”—in which high-frequency firms caught criticism for abruptly leaving the market—that could require electronic traders to stick with their trading throughout turbulent conditions. Competing firms have banded together to back advocacy groups in the U.S. and Europe.

There is another reason for firms to map out expansion plans, Mr. Tabb said. Computer-powered trading shops may one day look to sell their own shares as they establish broader-based businesses and private-equity investors seek to monetize stakes taken in recent years.

“You’re going to see them move up the value chain into different asset classes, geographies, trading styles and business models,” Mr. Tabb said. “A couple smart guys and couple fast computers is not a sustainable, long-term business model.”

—Jacob Bunge

Stock Trading

Volume Slowdown May Persist as Investors Stay Risk-Averse

A persistent slump in U.S. stock-trading activity is seen extending into 2012 as European debt woes and a sluggish economic recovery in the U.S. give investors few reasons to put money at risk, analysts say.

Exchanges, banks and brokers, already under pressure after two years of declining market volumes, could be forced into further consolidation and restructuring to confront the slowdown.

“We’re all coming to grips with the fact that the industry has changed,” said Alison Crosthwait, managing director of global market structure for electronic brokerage firm Instinet Inc.

The U.S. stock market closed out 2011 with an average 7.9 billion shares traded per day, about 6% below 2010’s daily average of 8.5 billion, which was lower than 2009 levels.

Trading floors are seen being even quieter in 2012. Keefe Bruyette & Woods forecast that an average 7.4 billion shares will change hands per day in 2012, down 7% from 2011, as investors stick to the sidelines after a year of often-jarring volatility.

A jumpy market, liable to turn on a dime based on headlines out of Europe, has made stock-picking harder for individual investors and hedge-fund managers alike, Ms. Crosthwait said. The dominance of big-picture issues—such as the fate of the euro zone—have influenced many securities to trade similarly, slimming the odds that a savvy buyer can zero in on a winner.

“People are looking for some sense of security from Europe, stability in [U.S.] unemployment and consistency out of our federal government,” said Ben Schwartz, chief market strategist for Lightspeed Financial Inc.

“Until we get that, it’s going to be a rough show.” Mr. Schwartz said he anticipates stock-market volumes to otherwise stay flat in 2012.

Slow markets can also be more expensive places to do business. If fewer traders are quoting prices for a given stock, the spread between the bid and offer for that stock is likely to be wider—meaning that an investor will pay more to enter or exit from a position.

—Jacob Bunge

Exchange-traded funds

Caveat Investor: Small, Niche Vehicles Are Prone to Closure

The booming exchange-traded-fund industry is still, well, booming. But 2011 showed that ETF closures are probably here to stay, too.

The 1,369 exchange-traded funds in the U.S. are built to track everything from stock indexes like the Standard & Poor’s 500 to high-yield bonds and niche areas like nickel and Colombian stocks. Before the financial crisis, fund closures were rare. But fund deaths picked up in 2008 and have remained steady at a few dozen a year as the industry has ballooned to nearly $1.1 trillion in assets under management. In 2011, amid the launch of more than 300 new funds, there were more than 30 closures.

Analysts attribute the closure wave to the rush of new, smaller ETF sponsors seeking to cash in on the boom. While more than 80% of assets in ETFs are in funds sponsored by BlackRock Inc., State Street Corp.’s State Street Global Advisors unit and Vanguard Group Inc., 40 or so smaller firms have the rest of the business. Many aren’t as gun shy as the big firms about closing down weak funds. BlackRock’s iShares, State Street’s State Street Global Advisors, and Vanguard, weren’t the sponsors of any of the more than 160 ETFs that closed from early 2008 through mid-October of 2011, according to research by XTF.

“Some of the new entrants into the ETF space are not as careful about the products they launch,” said Scott Kubie, chief investment strategist at CLS Investments, which manages $7 billion. “They’re hoping to take advantage of a field that’s growing quickly. Those ETFs are likelier to close.”

To some industry participants, closures are just the ETFs market’s way of pruning its unfruitful branches. But a closure can mean a number of headaches, for instance leaving investors on the hook for unexpected capital-gains taxes. It can also upset long-term investors’ diversification plans, as the money they plunked into a niche area is returned.

What is certain is that ETF sponsors will face more pressure to close small ETFs in 2012 unless assets under management somehow ramp up sharply. About 53% of all U.S. ETFs manage less than $50 million, up from 43% a year ago, according to XTF. Having $50 million to $100 million is a rule of thumb for industry participants to guess whether an ETF can cover its costs.

Two years is a common time frame to assess whether an ETF should be reconsidered, said Bill DeRoche, chief executive of QuantShares, a company focusing on “market neutral” ETFs.

Most doomed ETFs have been ones that track highly specific investment niches, like the FaithShares Methodist Values Fund, which closed in July, or the MacroShares Major Metro Housing Up Shares ETF, which shut down two years ago. But there are plenty of niche ETFs with low assets and staying power. Whether they close usually comes back to the sponsor, analysts say.

Investors should look to the provider’s track record to judge the likelihood of a closure, according to analysts. Meanwhile, the bigger ETF providers take pains to stress that they don’t single out a given fund from its larger fund grouping if one happens to be this year’s underperformer.

“We want to bring things to market for the long term,” says Noel Archard, head of iShares global product development and management at BlackRock. “At any given period, any one of the funds is going to be in favor while others will be out of favor. That’s not a concern.”

—Brendan Conway

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