At some recent conferences and a government roundtable we have attended a reoccurring theme is the debate between transparency and liquidity. But we think there is a piece of the puzzle missing.
The theory is that one major objective, if not the primary one, of Dodd-Frank et al. is to create a more transparent market. The regulators channel the U.S. Supreme Court Justice Louis Brandeis’ quote: “sunlight is the best disinfectant”. But market participants argue too much transparency and the information can be used against the investor, resulting in reduced liquidity. This is especially true for the institutional guy with big size to do. Too little transparency and we are off to the systemic risk races.
How does transparency reduce liquidity? One example are block rules which regulate off-exchange trading and report timing. They were debated at the recent CFTC roundtable on the futurization of swaps. Potential differences in disclosure timing between cleared OTC swaps, going through SEFs, versus swaps futures going through exchanges were highlighted. But the reduction in liquidity goes much deeper. Increased capital requirements have made market making less attractive to banks. For example, corporate bond inventories, despite huge issuance, is a fraction of what it used to be. Without being able to hold paper, banks are reduced to simply passing though trades. Market depth disappears and that leads to volatility. If a broker/dealer cannot find the other side, the trade doesn’t happen or the terms tend to where the return on capital becomes attractive. The Volcker Rule prevents banks from providing liquidity through their prop desks.
If the banks aren’t there to offer liquidity, who will? The answers have focused on more lightly regulated entities – think shadow banks and hedge funds in particular. Stepping into the role of buyer of last resort they provide an enormous service to the market, albeit they get their pound of flesh for their troubles. But wait a second. Who funds the hedge funds? Are they doing this business with only their investor’s cash? No. Hedge funds are leveraged animals. Where does the money come from? Well, the banks. The risk of outright positioning is swapped for contingent repo risk. The latter may be less risky on a micro basis, but is highly opaque. Do banks really know the detailed positions that their hedge fund clients have away from them? Can they ever get a full picture of their counterparty risk? The risk is still there, only it has morphed into a form far less visible. When regulators think about shadow banking, they need to pay close attention to how their rules and regs interact with each other.