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The lack of liquidity in the bond markets has drawn significant attention from policymakers, but agreeing on what is causing it, and whether new regulations required by Dodd-Frank are to blame, may be impossible.
August 24 -
Federal Reserve Board Gov. Jerome Powell and the top adviser to Treasury Secretary Jack Lew said that, based on the recent autopsy of the October 15, 2014 spike in Treasury yields, there is reason to believe that high-frequency or algorithmic trading may elevate the risk of similar events in the future
August 3 -
Federal Reserve Board Chair Janet Yellen sounded at least open to the idea that new regulations have contributed to potential liquidity problems, but said more study is needed.
July 15
WASHINGTON — The question of whether new liquidity rules are having a dramatic negative impact on capital markets continues to rile regulators and the financial industry, with policymakers providing ammunition to both sides of the debate just this week.
On the one hand, William Dudley, the president of the Federal Reserve Bank of New York, downplayed industry worries about a liquidity crunch, suggesting they were overblown. But his comments came just after the International Monetary Fund previewed a report suggesting that market liquidity may soon get worse.
Speaking at a conference in New York on Wednesday, Dudley said that examiners "do not find much evidence" that liquidity in the Treasury bond market is constrained. Even if illiquidity emerges, however, Dudley said there is little evidence to support the argument that the Dodd-Frank Act and its rules are the cause.
"Some opponents of tougher bank regulation claim that the increased regulatory requirements, such as the higher capital requirements and new liquidity standards … have reduced these firms' market-making capacity," Dudley said. "This is a noteworthy assertion and would have significant implications for regulatory policy if it were correct. However … I don't think the hypothesis is well-supported by the available evidence."
Dudley acknowledged that if discrete regulatory changes can be identified that will improve demonstrable liquidity mismatches without undermining the benefits of higher capital and liquidity rules, the Fed and other regulators should be willing to make those changes.
"If there are adjustments to regulation that could improve liquidity provisions without increasing financial stability risks, we should be open to considering such changes," Dudley said.
Dudley's assertions came as the IMF published a summary of a forthcoming Global Financial Stability Report on Tuesday highlighting potential risks to financial markets — particularly corporate bonds — from illiquidity once the Fed begins raising interest rates sometime later this year or early next.
Gaston Gelos, chief of the Global Financial Stability Analysis Division at the IMF, said that low interest rates and the related reach-for-yield behavior of the investment community have made the markets appear more liquid than they actually are.
"In recent years, factors such as investors' higher risk appetite and low interest rates have been masking growing underlying fragilities in market liquidity," Gelos said.
The IMF report, which will be published Oct. 7, does not call for a rollback of liquidity or capital rules in order to enhance market liquidity, but instead advocates for an expansion of access to electronic trading to deepen markets and increased standardization of financial products to reduce fragmentation.
But these solutions are unlikely to eliminate the problem entirely, Gelos said.
"It is crucial that we continue with market infrastructure reforms that improve the resilience of liquidity, such as guaranteeing equal access to electronic trading platforms or fostering instrument standardization," Gelos said. "At the same time, central banks and financial supervisors need to be prepared for episodes of liquidity breakdowns."
The dueling interpretations of whether market liquidity as it exists today poses an imminent threat to financial stability is consistent with the prevailing narratives that have emerged in recent months.
Regulators and administration officials — including Fed Chair Janet Yellen, Treasury Secretary Jack Lew and Fed Gov. Daniel Tarullo — have insisted that there is not enough evidence of a liquidity crisis and even less reason to assume that Dodd-Frank is to blame for whatever illiquidity can be observed. Other factors, including the rise of high-frequency trading and the overall reduced appetite for risk, have also likely contributed to disjointed market conditions, they say.
Administration opponents in Congress and industry groups, meanwhile, have pointed to market liquidity as evidence that capital and liquidity requirements envisioned in Basel III and Dodd-Frank have had unintended and severe consequences. The House Financial Services Committee has held hearings on the issue and questioned regulators on the matter in their regular oversight hearings.
The IMF's examination of the issue adds a new dimension to that argument. The forthcoming report estimates that 80% of liquidity in U.S. investment-grade bonds since 2010 can be attributed to the low-interest rate environment and the pursuit of higher yield, suggesting that the apparent lack of indigenous demand for those products could disturb the market as those underlying conditions change. But the report makes a point of saying that new capital rules cannot be singled out as a cause, since those rules have not been fully enacted in many jurisdictions examined in the survey.
"Not enough time has passed for a proper evaluation of the role of new bank regulation behind these developments, since countries are only now implementing some of these new rules," the report said.
