Is Regulation the Reason Liquidity Is So Unstable?

WASHINGTON — 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.

Republican lawmakers have held a recent spate of hearings on illiquidity largely focused on the connection between Dodd-Frank capital requirements and the apparent illiquidity in what have historically been very liquid markets. It's an issue they are likely to return to when Congress returns to session next month, particularly in light of stock market volatility on Friday and Monday, which could underline the potentially fragile state of the economy.

But figuring out a definitive answer about how Dodd-Frank is contributing to alleged illiquidity is challenging. Consumer groups are deeply skeptical of the debate, arguing it is just a talking point for the regional and big banks to weaken Dodd-Frank.

"It's basically an attempt to put up a sort of fog of complicated technical terms around industry's desire to reverse pretty basic financial reforms," said Marcus Stanley, policy director for public advocacy group Americans for Financial Reform. "There's no academic consensus on any single best way to measure [liquidity] … so you can raise it as this boogeyman in a way that is not really particularly connected to the substantive issues."

But Wayne Abernathy, an executive vice president with the American Bankers Association, said the instability in the liquidity markets is real, but its cause is unclear. He cited fixed income liquidity as a source of concerns for regulators and lawmakers, but said liquidity is hard to define, much less measure.

"It's not the kind of thing that lends itself to precise measurement," Abernathy said. "If you went back and tried to measure the liquidity problems of 2007, 2008, 2009 — everybody knows there [were] major liquidity issues, but try to put a number on it."

Lawmakers have been hammering the issue. The House Financial Services Committee held a hearing July 23 about the "proper role of capital and liquidity," while Rep. Randy Neugebauer, R-Texas., held a roundtable discussion on July 13 to examine fixed-income liquidity. The issue of liquidity in the fixed-income markets also played a prominent role in the House Financial Services Committee's hearings with Treasury Secretary Jack Lew, who also heads the Financial Stability Oversight Council, and with Federal Reserve Board Chair Janet Yellen.

Yellen said during her hearing in the House committee last month that regulation "could've contributed in some way" to liquidity issues in the market but added that "there are many other things going on as well." Lew was more categorical, saying during his FSOC oversight hearing in June that he does "not see a major impact in terms of broad liquidity."

Speaking at a forum in New York in June, Fed Gov. Daniel Tarullo said that there were some indications that liquidity was more constrained today than it was before the financial crisis and that regulation had contributed to that tightness. But he said that the pre-crisis liquidity indicators that the industry yearns for was "illusory" and did not act as a cushion for the markets when the crisis hit.

The Treasury and other regulatory agencies completed a report last month examining the causes of a spike in Treasury bond yields last October and concluded that there were a number of contributing factors but no single cause. And the Federal Reserve Bank of New York last week began a series of blog posts on market liquidity, focusing much of its attention on the rise of high-frequency and algorithmic trading and its possible role in precipitating or exacerbating market shocks, as well as the role of regulation and an organic shift to prudence on the part of market participants after the crisis.

The industry has attempted to prove that a liquidity crunch is occurring. The Global Financial Markets Association and the Institute for International Finance, meanwhile, released a report August 12 outlining the lack of liquidity in the secondary bond market and highlighting the effects that that illiquidity might have in a stress event. The report, by Nick Forrest of the accounting services consultancy PricewaterhouseCoopers, concluded that regulations played a major role, along with other factors, in creating that market tightness. Forrest said that regulators should consider the financial stability effects of any new rules before putting them into effect.

"Our analysis suggests it is important for policymakers to consider the aggregate impact of current regulation and weigh the incremental financial stability benefits of new rules against the incremental costs of diminishing market liquidity to ensure regulation is not counterproductive," Forrest said.

Fixed-income markets — particularly Treasuries — have traditionally served as a safe, liquid but low-yield place to park capital in times of stress. But since the crisis a number of different factors have made those traditionally safe and sleepy assets more desirable.

A shift toward more prudent investments, a low-interest rate environment, and requirements for banks to hold greater reserves of high-quality liquid assets have driven many market participants to buy and hold bonds where they might previously have traded more actively. That means fewer transactions and fewer assets with which to transact, making it harder for participants to deal in size or at the time and price of their choosing. In a stress event — such as a drop in equity or futures markets — bonds are often the place that investors go for refuge, and many experts fear that illiquidity now could be a sign that a future crisis could be made far worse because of a breakdown in the fixed income markets.

High-frequency and algorithmic trading, meanwhile, have exploded in fixed income markets since the crisis, accounting for a significant share of all transactions. The role of automated trading in market behavior, however, is poorly understood and to date there are few basic requirements that such traders have to meet in order to participate in financial markets.

Abernathy said he didn't think that the liquidity issue has gotten overly political so far, but he is concerned that if it does, it will make it all the more difficult to identify consensus solutions.

"We would very much hope that this doesn't become a political football, because it is a very important economic and financial problem to be addressed," Abernathy said. "I think the key thing is … let's address it now, when it's easier to address, with the things that we can do."

Karen Shaw Petrou, managing partner for Federal Financial Analytics, said that the question of who is politically responsible for whatever market illiquidity is occurring in the markets is clouding the more pressing problem of how to resolve it, or at least float ideas on how to solve it.

The entire concern about illiquidity is the ability of market participants to shelter their funds away from more volatile markets in times of stress, and there are ample prospective stress events to worry about in the near term, Petrou said. The escalating war in the Middle East, a fragile European economy and the downturn in the Chinese manufacturing sector are only some of the many factors that could lead to a broad dampening of the global economy, Petrou said, and if the bond market is not prepared to handle that kind of a stress event, it could make any systemic shock all the more painful.

"The market conditions are really fragile. It's scary out there," Petrou said. "This debate, which is not about constructive incremental solutions, but rather … the political, ideological, theological debate is just going to make the markets much more vulnerable."

One of the solutions Petrou suggested was amending the Fed's leverage ratio rules for banks to exempt cash reserves held at Federal Reserve Banks from the rule. The leverage ratio is meant to provide a window into banks' balance sheets that is not clouded by presumptive risk weighting — a position designed to avoid the low- or zero-risk weights that mortgage-backed securities and sovereign bonds enjoyed before the financial crisis. But because the ratio treats all assets the same, regardless of risk, it effectively incentivizes banks to hold riskier assets that may offer a higher yield to lower risk but more liquid assets that will be weighted the same and offer less yield. Making an exemption for cash — which, of course, is highly liquid — would make banks more liquid and take pressure off their need to acquire high-quality liquid asset bonds, Petrou said.

Abernathy said the ABA is pushing for a more diversified range of assets to qualify as HQLA to take some of the pressure off Treasury markets and give banks more markets to choose from when meeting liquidity coverage ratio requirements. Abernathy noted that the Fed already moved part of the way in this direction by adding certain municipal bonds to the list of acceptable HQLAs.

Changes to the Volcker Rule could also be made to facilitate market-making in areas that are lacking credible counterparties, he said. But none of those reforms should be viewed as a pretext for undermining the central purpose of Dodd-Frank, Abernathy said.

"You don't have to throw out the liquidity coverage ratio in order to make it work better — you just expand what qualifies as HQLA. You don't have to throw out the Volcker Rule — you can just improve the flexibility to allow more market-making to take place," Abernathy said. "I think by trying to keep it from being politicized and focusing on where the real problems are, we address those problems and still retain the key reforms."