Many factors are likely to be contributing to lower liquidity, but financial reforms are often cited to have had one of the greatest impacts. Regulatory changes under Basel III and the provisions of the Dodd-Frank Wall Street Financial Reform and Consumer Protection Act of 2010, including the Volcker Rule, instituted greater capital and liquidity requirements for banks, and prohibited banks from engaging in proprietary trading. These requirements have led to reductions in dealer inventories as well as limited their ability to act as effective market-makers. At the same time, the market has seen record new corporate bond issuance as corporations take advantage of the low interest rate environment. Accordingly, a larger market is being supported by a lower degree of market making and this structural imbalance has served to heighten concerns.
Several behavioral changes have been observed in response to diminished liquidity. Traditional market-makers appear more hesitant to take on large positions on behalf of their clients. Average trading sizes across the market have decreased while execution times and the associated risks for large block trades have increased. Additionally, markets have began to show signs of liquidity bifurcation with more trading activity concentrated in the most liquid products and diminished activity in the less liquid ones.
Market participants and regulators continue to debate the appropriate level of liquidity in fixed income markets as they seek to strike a balance between financial stability and efficient capital flow. There has been increased discussion on alternative solutions that could help reduce the existing market frictions and provide incremental liquidity. Certainly there has been increased competition among electronic trading venues in the fixed income markets as the market experiments with ways to enhance the price discovery process and provide faster and easier ways to connect with more counterparties. Regulators are also exploring ways to enhance transparency and liquidity in our markets and have encouraged market participants to evolve fixed income market structure as much as possible.
Liquidity discussions are being held for example at the global level at the Bank for International Settlements and the International Organization of Securities Commissions as well as at the regional level here in the U.S. and in the European Union.
Robust market liquidity is essential to efficient capital market functioning. SIFMA supports continuing efforts by regulators and market participants alike, to analyze liquidity while trying to strike the appropriate balance between promoting financial stability and maintaining financial market efficiency.