The Volcker Rule and the Hedge Fund Liquidity Circle

Abstract

This paper finds that the implementation of the Volcker Rule (section 619 of the 2010 Dodd-Frank Act) profoundly impacts overall equity market liquidity, the funding liquidity of hedge funds, and their liquidity provision to the market. Analysis of a sample of 8,686 hedge funds reveals that subsequent to the Volcker Rule, funding flows to hedge funds decline, and their flow-performance sensitivity increases. Hedge funds also reduce their exposure to market liquidity and realign their market-making activities to the most liquid segment of stocks. The impact appears more pronounced for those funds with business connections to systemically important US banks, weak past performance, and adopting non-directional investment strategies.

Keywords: Volcker Rule, Hedge funds, Liquidity risk, Market liquidity

JEL Classification: G1, G18, G2, G23, G28