Fixing the plumbing of liquidity in financial markets

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It became very clear that liquidity was the blood of the financial system during the financial crisis of 2008 – large injections of liquidity were necessary to save bleeding banks. Regulations were enacted to prevent such crises from reoccurring, but the irony is that we have just discovered the negative side effects of regulation on market liquidity. Corporate bonds now have to be backed by healthy amounts of capital and collateral to endure a more stressful Fed stress test. The Volcker rule further restricts proprietary trading causing banks’ failure to provide near-term client demand for market-making activities, leading to bigger volatility in market prices. Moreover, in search of safe investments, large institutional investors have become major players in the fixed-income space in light of low interest rates. These safe investments are usually illiquid but investors can redeem them overnight via open-ended Exchange Traded Funds. When the Fed moves toward interest rates normalization eventually, large holdings in bond funds are very vulnerable to redemptions as bond prices fall.

Dealers will not be able to act as shock absorbers in the event of one-way traffic out of bond holdings. I feel it is imperative that regulators look at new rules collectively, not in isolation. If regulation impedes ‘business-as-usual’ trading activity, investors are highly unlikely to trade in times of crisis. Regulators must allow some flexibility amidst stricter balance sheet rules. Some trades weigh on balance sheets in the shorter term but might be very low-risk and able to act as the missing ‘shock-absorbers’. Though we cannot just merely blame regulation – in times of crises dealers equally participate in fire sales of their bond inventories. It is normal for liquidity to be present when markets are healthy and disappear when it is most needed. In the long run, there will definitely be some adjustments by dealers to adopt more client-tailored trading activities. Robert Michele of JPMorgan Asset Management has stated that market participants will need to be investors again rather than just traders. Prior due diligence and research is even more crucial and emphasis has to be put on bond exit strategies as a pay-off as opposed to an emergency exit plan. Fund managers / traders must make it a point to examine an investor’s liquidity needs when purchasing ‘liquid’ securities in an environment of illiquidity.

Renowned economist Nouriel Roubini has gone as far as to say that the combination of illiquidity factors we discussed and loose monetary policy is a ticking time bomb. When external shocks (Fed rate hike, commodity price volatility, Emerging markets’ currency shocks) occur, “herding in the opposite direction” happen and dealers who largely absorbed these shocks on their once unrestricted balance sheets are no longer in the picture. Maybe he is right to say that this bubble will eventually burst with catastrophic impact on the wider economy, but the markets will evolve vis-à-vis the status quo. We are just not sure of the speed of the market corrections so in the meantime it is important that market participants acquaint themselves with the idea that they can no longer depend on dealers to provide liquidity in markets and while dealers should adopt more client-oriented strategies, issuers must be aware of consequences of market conditions on their debt burden. Regulators must find this delicate balance between the cost and benefits of their new rules. As we fix the plumbing of the financial markets, a positive outcome we can hope for is greater investor discipline and risks being better spread out throughout market participants so that the economy is not totally reliant on "too-big-to-fail" banks.