Why has liquidity decreased in the markets? Daniel Tarullo says he isn’t sure.

An interview last Thursday with Federal Reserve Board Governor Daniel Tarullo, discussing possible reasons for the October 15, 2014 Flash Crash in US Treasuries, shows regulatory uncertainty for why, at least anecdotally and at times pointedly, market liquidity has pulled back. Tarullo worked both sides of the regulatory fence in his comments, noting that regulations may have played a role but that also market makers may be acting no differently than they have in the past. What indeed is causing liquidity troubles? The answers aren’t that complicated; the trouble is that solutions may mean that regulators have to double back on their desires for less-risky banks.

The conversation with Tarullo happened on Thursday June 25, 2015 at the Council on Foreign Relations in NYC. Here are excerpts from his response to a question about liquidity:

– Ten years ago, there was an enormous amount of liquidity sloshing around the markets. Much of that liquidity proved to be illusory in the sense that when there was an exogenous shock that produced a lot of uncertainty about the value of underlying assets, the buyers, in many instances, just withdrew from the market.

– We shouldn’t equate the existence of large balance sheets in normal times with a buffer against stress in the sense that those balance sheets will be available to buy the assets that people are trying to unload during a period of stress and uncertainty.

– Having said that, there does seem to be something different in markets, even operating in non-crisis, non-stress periods, as we are at the present. By some metrics, things like bid-ask spreads, doesn’t seem to be too very much different. By some other metrics—market depth, the anecdotal information you hear about the difficulty, perhaps, in moving large positions, something may—does seem to have changed.

– There are changes in the regulatory environment, for sure.

– Those things are presumably contributing, but I think it’s a little difficult. And I must say, having had a lot of conversations with, I think, very fair-minded people from within the industry, from within markets, academics and the like, I don’t think there’s a—there’s at this point, a very precise and convincing explanation of exactly what has happened. We do need to understand that, and we need to understand whether those changes are posing more financial stability risks and, if so, then see what would be the appropriate response.

We were a little surprised to hear such uncertainty from Tarullo about what the potential causes are for the current state of market liquidity. We emphasize fixed income markets in our observation. We see three big ticket items:

– Less Balance Sheet. We agree with Tarullo that a big balance sheet does not ensure liquidity provision but at the same time, a smaller balance sheet pretty much guarantees less liquidity. That’s what we have today.

– Pullbacks in securities finance. This one is obvious: every article on markets either says it directly or indirectly. Here’s a recent Bloomberg headline: Liquidity Squeeze Hits Repos in Denmark as Market Makers Retreat. Here’s another one: Treasury 10-Year Note Repo Shortage Sends Rates Below Zero. We think the question here is less about what is going on than about how to reconcile regulatory desires for very low risk banks with the needs of many, many market participants for liquidity.

– Algorithmic trading. Automated trading encourages a herd mentality driven by market signals. If one tick sends the market into a particular direction with nothing to keep it in check (like market making, repo or some other source of liquidity) then the market will head off into the sunset. We’ve seen this countless times in the equity markets. Fixed income is simply what’s next.

We appreciate that Fed Governor Tarullo is uncertain, but it shouldn’t be hard to find the root causes of the problem. As always, there is a direct conflict between the gold standard of regulation and the realities of the market. This may be time for regulators to be more flexible in their policy making in order to ensure a beneficial outcome for markets, investors and ultimately the global economy.

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