Governor Powell sticks to a proscribed script; that the bond market has shown no signs of a loss of liquidity and that even if dealers have reduced their trading books there are plenty of other actors that will take up the slack. This often repeated mantra is either naïve or overly optimistic.
The traditional dealer centered market model has served two primary purposes. First, the dealer through his retail network can connect buyers with sellers in a cost efficient manner. Second, the dealer is prepared to stand in as either buyer or seller when there is no offsetting demand from the opposite side of the market. While electronic trading platforms can address the former, there is no replacement in the market today for the latter. In the new post 2008 regulated environment, dealers have rationed their balance sheets and most trading desks operate near their allotted share to maximize revenue but also to avoid losing precious capacity. Hence, when the market gets hit with a wave of selling they are not in a position to ‘take down’ any more inventory. Governor Powell and the other regulators may view this as desirable in that ‘too big to fail’ banks and credit institutions who’s liabilities are guaranteed by the FDIC will not increase their risk profile in times of stress. They are convinced that ‘retail’ will step into the breach. Non-levered investors will never be in that position to support the market in a large way because they are generally close to fully invested already. Levered investors (hedge funds) may want to step in if prices fall far enough but guess what? In order to buy they need one thing: leverage. Who supplies that leverage….oh, it would be the same dealers that are at capacity now. So we come back to the same problem. There is no elasticity in the bond markets today. This will lead to continued market volatility.
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Governor Powell sticks to a proscribed script; that the bond market has shown no signs of a loss of liquidity and that even if dealers have reduced their trading books there are plenty of other actors that will take up the slack. This often repeated mantra is either naïve or overly optimistic.
The traditional dealer centered market model has served two primary purposes. First, the dealer through his retail network can connect buyers with sellers in a cost efficient manner. Second, the dealer is prepared to stand in as either buyer or seller when there is no offsetting demand from the opposite side of the market. While electronic trading platforms can address the former, there is no replacement in the market today for the latter. In the new post 2008 regulated environment, dealers have rationed their balance sheets and most trading desks operate near their allotted share to maximize revenue but also to avoid losing precious capacity. Hence, when the market gets hit with a wave of selling they are not in a position to ‘take down’ any more inventory. Governor Powell and the other regulators may view this as desirable in that ‘too big to fail’ banks and credit institutions who’s liabilities are guaranteed by the FDIC will not increase their risk profile in times of stress. They are convinced that ‘retail’ will step into the breach. Non-levered investors will never be in that position to support the market in a large way because they are generally close to fully invested already. Levered investors (hedge funds) may want to step in if prices fall far enough but guess what? In order to buy they need one thing: leverage. Who supplies that leverage….oh, it would be the same dealers that are at capacity now. So we come back to the same problem. There is no elasticity in the bond markets today. This will lead to continued market volatility.