Rep. Randy Neugebauer (R-Texas)
“Fixed Income Liquidity Roundtable”
Monday, July 13, 2015
Key Topics & Takeaways
- Problems with Liquidity: USC’s Harris offered a pair of questions to ask as regulators consider issues of liquidity: 1) whether liquidity is being temporarily affected by a “reorganization” of the market as liquidity provisions shifts away from banks; and 2) whether strong-enough systems can be put in place to defend against investors’ overreaction whenever interest rates rise and investors try to “run for the exits.”
- Regulatory Impact: J.P. Morgan’s O’Connor stated that about 40 percent of rulemaking has yet to happen, and urged that regulators should “take a pause” to look at the current balance of safety and soundness with the effectiveness of capital markets.
- Going Forward: SEC Commissioner Gallagher said the Financial Stability Oversight Council should be looking at liquidity “rather than designating insurance companies.” He also said regulators should work together to look at market structure now, and that the “worst thing” would be for Congress to “come in and write a Title VII” for fixed income markets.
- Rep. Randy Neugebauer (R-Texas)
- Daniel Gallagher, Commissioner, Securities and Exchange Commission
- Sharon Bowen, Commissioner, Commodity Futures Trading Commission
- Dr. Nellie Liang, Director, Office of Financial Stability Policy and Research, Federal Reserve Board
- Sandie O’Connor, Chief Regulatory Affairs Officer, J.P. Morgan Chase & Co.
- Kathleen Yoh, Deputy Treasurer of Funding, GE Capital
- Kashif Riaz, Managing Director of Trading and Liquidity Strategies, BlackRock, Inc.
- Dan Leland, Executive Vice President, Head of Capital Markets, Southwest Securities, Inc.
- Dr. Larry Harris, University of Southern California
Rep. Randy Neugebauer (R-Texas)
In his opening statement, Rep. Randy Neugebauer (R-Texas) explained that he chose to host a roundtable rather than a hearing on the issue of liquidity because he felt a need for more robust discussion and open dialogue on financial markets. He commented that regulators tend to focus on individual entities, but that a need exists to consider changes to the marketplace as a whole because they touch so many Americans. Neugebauer also noted that former Federal Reserve Chair Ben Bernanke himself had stated that no one has ever undertaken a quantitative analysis of the cumulative impact of post-crisis regulations.
Daniel Gallagher, Commissioner, Securities and Exchange Commission
Commissioner Daniel Gallagher stated that liquidity is a “hugely important” issue to discuss, and that he has been following it for about three years. While debt markets have worked well for decades, he commented, there is now reason to be concerned about a potential liquidity crisis coming with the normalization of monetary policy. He stressed that the Securities and Exchange Commission (SEC) “needs to up its game” in looking at liquidity issues, lamenting that it has not been a priority of the Commission to this point.
Sharon Bowen, Commissioner, Commodity Futures Trading Commission
Commissioner Sharon Bowen commented that she is very mindful of issues regarding liquidity and that she often hears the concerns from market participants. She noted that the biggest takeaway from the most recent meeting of the Commodity Futures Trading Commission’s (CFTC) Market Risk Advisory Committee was that regulators need to come up with a joint definition of liquidity in order to better understand the issue. She also said regulators should engage more with industry on the issue.
Dr. Nellie Liang, Director, Office of Financial Stability Policy and Research, Federal Reserve
Dr. Nellie Liang said market participants have expressed concerns about bond market liquidity, and that the Federal Reserve Board has been trying to look at measures of liquidity, though no single measure can show the whole picture.
Liang offered a series of factors that are affecting bond market liquidity today, including a smaller number of market participants, regulations’ effect on broker-dealers’ willingness to buy and sell securities, increased reporting costs, and algorithmic trading. However, she commented that liquidity risk has always been a concern, and that leading up to the crisis, risks were held by the most highly-leveraged broker-dealers. Liquidity risks have now shifted to less-leveraged entities like hedge funds, she said, and if these entities are well-prepared to handle this risk, than the markets as a whole may be better off.
Sandie O’Connor, Chief Regulatory Affairs Officer, J.P. Morgan Chase & Co.
Sandie O’Connor opened by stressing the importance of market-based lending, explaining that it supports consumers and that the strength of American capital markets are the reason the U.S. has seen a stronger recovery since the crisis than Europe. She agreed that there is a need to better define liquidity and offered her own definition as the ability to trade a security “when I want, and with reasonable price predictability.” She pointed out that the market has already seen volatility events, but that they have not been truly tested since the financial crisis.
O’Connor also discussed changes to market structure since the crisis. She specifically noted a higher reliance on electronic trading, changing behaviors by market participants as a result of both regulation and better risk management, a greater share of fixed-income securities being held by funds, and new rules on capital, leverage, and liquidity that have changed bank behavior. She further added that the impacts of the new rules, in aggregate, need to be considered, and that regulator focus should now turn to the resiliency of banks and capital markets.
Kashif Riaz, Managing Director of Trading and Liquidity Strategies, BlackRock, Inc.
Kashif Riaz agreed that fixed-income markets have changed as a result of post-crisis regulations, central bank policies, and reduced activity by broker dealers. However, he commented that the pre-crisis situation was not sustainable and that post-regulatory changes are a “natural thing.” Riaz stressed that liquidity is not a new issue, that market participants simply need to react, and that losses by investors must not be misinterpreted as systemic risk.
Riaz offered three recommendations from BlackRock: 1) modernizing market structure; 2) encouraging open trading; and 3) promoting the evolution of new and existing products and technologies that will make trading less capital-intensive.
Dan Leland, Executive Vice President, Head of Capital Markets, Southwest Securities, Inc.
Dan Leland stated that the level of technology and complexity required to comply with rules, such as those coming from the Basel Committee, are causing some firms to exit fixed-income markets. He also suggest that the Financial Industry Regulatory Authority’s (FINRA) Trade Reporting and Compliance Engine (TRACE) rules should be optimized to allow for larger trading sizes, and that FINRA’s and the Municipal Securities Rulemaking Board’s (MSRB) matched trade rule proposals should exclude institutional traders.
Kathleen Yoh, Deputy Treasurer of Funding, GE Capital
Kathleen Yoh said the prevalence of the question of fixed-income market liquidity itself shows that the bond markets are not functioning efficiently, because concerns have an impact on secondary market pricing and on new issue premiums that impact all businesses considering issuing debt. She stated that liquidity is a complicated issue, and that there is no “silver bullet.”
Dr. Larry Harris, University of Southern California
Dr. Larry Harris stated that liquidity comes from the willingness of parties to trade with one another, and that public traders, such as institutional or private investors, can be the other side of a trade. He suggested that the public must be allowed to supply liquidity to the rest of the public. To do this, he said, a procedure is needed that would allow people to profit from making trades and market information must be distributed widely enough.
Importance of Liquidity
Bowen said a consensus from the Market Risk Advisory Committee is that liquidity is “not a God-given right – it comes at a price.” She stated that regulators should all be thinking about liquidity together and ensure that there are incentives for liquidity provision.
Gallagher was critical of the SEC for not focusing enough on liquidity, and worried that problems are only exposed during panics, which then leads to bad policy decisions. He suggested that private market solutions are needed, and that this could be facilitated through discussions between regulators and the private sector.
Riaz said liquidity is important to asset managers such as BlackRock because they manage investments for many types of clients with both long-term and short-term interests, and the value of liquidity varies across asset classes and investment types.
Problems with Liquidity Today
Asked by Neugebauer whether there is a problem with liquidity today, Gallagher replied that according to data, debt issuance is rising but inventory is down, which means that liquidity is a problem that regulators must be aware of. He added that he will continue to “assume there is a lack of liquidity until proven otherwise.”
O’Connor said liquidity is about market participants expectations. She commented that before the crisis, trades worth over $500M could be executed with no effect on price, but that today that value is down to $120M.
Liang added that the key issue is whether investors are anticipating the liquidity of their trading, and that because liquidity cannot be predicted, attention must be given to proper risk management.
Harris said the bottom line is that someone needs to supply liquidity, and that regulators should be careful to make sure large entities are not inhibited by regulations, so that they are able to act during day-to-day trading and in times of stress.
Harris offered a pair of questions to ask as regulators consider issues of liquidity: 1) whether liquidity is being temporarily affected by a “reorganization” of the market as liquidity provisions shifts away from banks; and 2) whether strong-enough systems can be put in place to defend against investors’ overreaction whenever interest rates rise and investors try to “run for the exits.”
Bank Behavior and Impact of Regulation
Neugebauer asked to what extent banks have changed their internal models since the crisis of their own accord and not because of regulation. O’Connor answered that banks’ risk appetites have changed, and that even if all regulation was pulled back, liquidity today would be less than before the crisis. She admitted that minimum standards, such as those from the Basel Committee, “needed to be done,” but that each new rule seems to be written as if banks are not already complying with the previous rules.
On the notion of considering the aggregate impact of regulations, Gallagher noted that financial holding companies have been subject to about 300 new regulations since the crisis, and that this number “implies impossibility” in complying fully. He commented that market participants have reached a point where prudent risk management practices have already been put in place.
O’Connor added that about 40 percent of rule-writing has yet to happen, and urged that regulators should “take a pause” to look at the current balance of safety and soundness with the effectiveness of capital markets.
Harris agreed that regulations should be looked at to see if they are truly necessary or just disadvantaging some firms.
Gallagher said he has observed a recent “policy push” to vilify electronic and algorithmic trading as having impacted liquidity negatively, and called this a “misdirection” of blame. Bowen agreed that high frequency trading seems to “get a bad rap.”
Liang denied that electronic trading is meant to be vilified, but rather that it is still not fully understood by regulators.
Leland said electronic trading has led to higher transaction volume, but at smaller trade sizes. He commented that it lends itself well to the Treasury market, but not as well to corporate debt markets.
Solutions Going Forward
Neugebauer asked what can be done to ensure a robust marketplace and “give it space to be innovative.”
Riaz said the current market structure “feels a bit dated” and suggested that greater use of emerging technologies could lead to more transactions and “uncover liquidity.” Adoption of technologies that could make trading less capital intensive, he explained, could also lead to a more heterogeneous market. He pointed to his earlier recommendations as a series of incremental steps that in concert could improve the status quo.
Harris said that while electronic order matching may not work for all markets, there is room for electronic markets and facilities. He called for order-display facilities where prices are made public and prices cannot be traded through.
Gallagher said the Financial Stability Oversight Council should be looking at liquidity “rather than designating insurance companies.” He also said regulators should work together to look at market structure now, and that the “worst thing” would be for Congress to “come in and write a Title VII” for fixed income markets.
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