A major speech and congressional testimony were released by the Federal Reserve on two important topics for Securities Finance Monitor readers: fixed income liquidity and blockchain for clearing and settlement. This article reviews what was said and identifies some takeaways for market participants.
Fixed income liquidity
In “Testimony by Governor Powell on trends in fixed-income markets,” Federal Reserve Government Jerome Powell spoke before the Subcommittee on Securities, Insurance, and Investment, and Subcommittee on Economic Policy, Committee on Banking, Housing, and Urban Affairs on April 14 2016. The Fed has been very cautious to admit that regulations are tied to the high volatility and disruptive pricing we’ve seen in fixed income markets over the last two years. From tightening liquidity in corporate credit to wild, unjustified swings in US Treasuries, the fixed income markets have indeed been turbulent. Governor Powell frustratingly repeated this theme: “Some market participants have expressed concerns about low liquidity across fixed-income markets, although many recent studies have found it difficult to identify such a broad reduction.” A Federal Reserve study of sudden US Treasury price movements on October 15, 2014 “did not find a single factor that caused the sharp swing in prices.”
Powell states his support for regulation in reducing risk – this is an example of regulators taking the gold standard of risk as the priority ahead of supporting market liquidity… which is pretty troubling, since the whole point of markets is to provide liquidity to buyers and sellers (including retail investors and retirement savers). Powell says “My view is that these regulations are new, and we should be willing to adjust them as we learn. That said, we should also recognize that some reduction in market liquidity is a cost worth paying in helping to make the overall financial system significantly safer.”
Powell also takes what we see as a backwards view to seeing improvements in the market. “Where there is an unmet demand for liquidity, new market makers are emerging to meet that demand. For example, some PTFs are seeking entry to dealer-to-customer platforms for Treasury trading. Seven new electronic trading venues entered the market for corporate and municipal bonds over the last two years, and several more are preparing to launch this year.” While it is true that Principal Trading Firms (PTFs) and electronic platforms are entering the market, these are fair weather friends. PTFs have no obligation to provide liquidity in any period of stress and tend to disappear fast. Electronic platforms do nothing more than invite liquidity providers to meet at a central location. They are not providing liquidity themselves.
Powell’s testimony reiterates troubling themes we have already heard from the Fed. Our view is that liquidity in fixed income markets has been greatly damaged by regulation. Although Powell knows that market participants think this too, he continues to assert that even if it were true, that’s okay. We don’t agree.
Governor Powell’s full testimony can be found at http://www.federalreserve.gov/newsevents/testimony/powell20160414.htm
Blockchain for clearing and settlement
On a more positive note, in “The Use of Distributed Ledger Technologies in Payment, Clearing, and Settlement,” Federal Reserve Governor Lael Brainard spoke optimistically about the potential use of blockchain in financial markets including uncleared derivatives. Speaking at the Institute of International Finance Blockchain Roundtable on April 14, 2016, she said “change might hold promise for improving bilateral clearing, and might also help us think about the long-run trade-offs between bilateral and central clearing…. Likewise, digital ledgers may improve collateral management by improving the tracking of ownership and transactions.” Reading the tea leaves, this seems like a hint to say that if market participants develop blockchain technology to reduce risk and improve transparency, then that could result in less stringent regulation going forward.
Brainard brought up an important theme, which is that the roles of market actors could change as blockchain becomes more prevalent: “the possible development and application of distributed ledger technology has raised questions about potentially far reaching changes to multilateral clearinghouses and the roles of financial institutions as intermediaries in trading, clearing, and settlement for their clients. In the extreme, distributed ledger technologies are seen as enabling a much larger universe of financial actors to transact directly with other financial actors and to exchange assets versus funds (that is, to “clear” and settle the underlying transactions) virtually instantaneously without the help of intermediaries both within and across borders.”
Brainard signaled a welcoming stance at the Fed towards blockchain: “Overall we should be optimistic that a range of new technologies hold the promise of providing more robust security, resilience, and information. We cannot afford to assume that change necessarily equals greater risk.”
After Governor Powell’s disappointing take on fixed income liquidity, this positive spin on blockchain from the Fed was a welcome change.
The full speech can be found here: http://www.federalreserve.gov/newsevents/speech/brainard20160414a.htm.
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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.