Regulators, please adjust the rules to preference the underlying markets, not the derivatives markets

There is a fundamental liquidity problem in financial markets with a conceptually easy fix. The problem is that regulators have accidentally preferenced the use of derivatives over physical financing transactions for banks. We proved this out in a December 2015 research report, and it is evident from the strength of the listed and OTC derivatives markets compared with the high volatility and relative lack of liquidity in underlying markets. Regulators, the markets need your help.

The simple explanation for why this is happening is that on an average trade, banks have more incentive to finance their clients and provide hedging using a total return swap or an option or future on one hand, instead of a physical short or a margin loan on the other. When banks look at their balance sheet charges for each type of transaction, the derivatives side wins hands down especially if it can be netted. This creates lots of liquidity in the derivatives markets but leaves the equity and bond markets high and dry. We’ve seen this story repeatedly now: US Treasuries, Bunds and equities have all seen extreme cases of price volatility that can be directly linked to a lack of liquidity.
Taking just the news from January 2016, here are some recent quotes:

Bloomberg quoting Savita Subramanian, the chief equity strategist at Bank of America Merrill Lynch: “The market is throwing a bit of a tantrum at the Fed call in December but what’s more problematic is the fact we’re in a liquidity vacuum.”

Bloomberg again: “A siphoning of the global liquidity punch bowl is fueling the 2016 downdraft in global equities, says Matt King, Citigroup Inc.’s head of credit product strategy, jumping on a thesis first promulgated by Deutsche Bank in September.”

A recent Bank for International Settlements paper on fixed income liquidity found that “fixed income markets are in a state of transition. Dealers have continued to cut back their market-making capacity in many jurisdictions. Demand for market-making services, in turn, continues to grow. The effects of these diverging trends have, thus far, not manifested themselves in the price of immediacy services, but rather they are reflected in possibly increasingly fragile liquidity conditions.”

Derivative market liquidity meanwhile is doing fine. According to a January 2016 Bank of England paper, ““the improvements in transparency brought about by the Dodd-Frank trading mandate have substantially improved interest rate swap market liquidity.” We also note that ETF options are now 70% of US equity options trading. 70%. And that’s a derivative of a derivative.
The wonky reason for why derivatives are in good shape but underlying markets are not has to do with some of our favorite regulations. Existing derivative capital regulations and the upcoming Standardised Approach for measuring counterparty credit risk (SA-CCR) provide banks with better capital treatment than physical transactions. Meanwhile, the combination of the Leverage Ratio, Liquidity Coverage Ratio and the Net Stable Funding Ratio have combined to discourage banks from physical transactions if no netting or an alternative trade exists.
A classic Tragedy of the Commons is unfolding. Each individual actor is doing exactly what they are supposed to in order to enhance their own positions. Unfortunately, that collective action is laying trade after trade into the derivatives market while underlying markets see less liquidity and more volatility.
This is a recent man-made situation, not a construct of history nor investor preferences. Regulators can alter the liquidity equation by making the balance sheet costs of derivatives and physical financing trades equal. If you can imagine that the balance sheet cost of a basket of securities loans is equivalent to the same client exposure (XVA) as a Total Return Swap, you get the idea. It may be a stretch for the regulatory imagination, but the current outcome looks unsettling. And while its true that a lightening up on Securities Finance Transactions causes concern about Shadow Banking, it is much better to take action now while the markets are just stormy and not a full blown hurricane.

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