Why You Should Learn to Love the Brave New World of Low Liquidity

The Financial Times reported earlier this week (hat tip Scott) how banks are cutting the size of corporate bond trading desks and reducing the size of trading inventories, all as a result of big bad regulations. As a result, the banks would like us to know, investors might be hurt by a lack of liquidity! Horrors!

The reporter, Tracy Alloway, is too savvy to take this at face value. She points out that the banks may well be using regulations as a fig leaf to do what they’d like to do at this point in the interest rate cycle more aggressively than usual, which is cut position sized. Dealers are normally expected to make a market in reasonable sizes in instruments they profess to cover. But when interest rates rise, they are are guaranteed to take losses on any bond inventories they hold. The Fed is making very clear it intends to taper, but the when and how it will begin is still up in the air. Nevertheless, the banks would like to get out of the way of this freight train and reduce the size of their inventories, which also means staying committed to not taking on much inventory. That in turn implies much less aggressive bidding when clients ask for prices, particularly if the client has a large position to unload:

“The dealer firms are saying Dodd-Frank – they shout it at you,” says Mr Fuss at Loomis Sayles. “That’s true to a point but the other point is that it’s pretty clear to most of the world that interest rates are heading up.”

But regardless of how much of this problem really is created by regulations and how much is banks using their desire to carry fewer bonds as an excuse to harp on Dodd Frank and other infringements on their imperial right to profit, dealers and investors have conferred on what to do about it, inconclusively. And investors perceive that they are at risk if dealers are more cautious about making markets:

But some bankers say the investor rush into corporate bonds and other fixed-income assets is part of the problem. The size of the outstanding corporate bond market has grown 42 per cent since 2008, according to Sifma data, as companies scrambled to refinance their debt in a period of historically low interest rates….

Bankers note that the booming primary market, where new bonds are sold, effectively masked the cracks in the pipes of the secondary market where the bonds change hands between owners. Instead of a vibrant secondary market, new issues have been held in big investors’ portfolios like rare museum pieces. That could increase volatility in the debt market and eventually lead to investor losses.

“It’s not that the dealer inventories have decreased so much. The problem is that the ratio of the assets under management in the fund community to the dealers’ inventory has increased dramatically,” says one senior banker at a large US bank. “All the investors have been doing is buying the new issues. Because there was such a one-way flow of money in, there was not a lot of need to rotate into other portfolios. The need for counterparty liquidity wasn’t there.”

The article describes efforts to create electronic trading platforms for bonds and makes it clear these venues haven’t attracted enough trading volume to be viable. I find it curious that Alloway treats these platforms as a new idea. I worked on a proposal for a distressed debt platform in 1999; Alloway’s colleague and fellow FT writer John Dizard was pedaling another concept that targeted different and bigger swathes of the bond business. And Goldman (and I believe other dealers) tried launching a bond research and trading portal in the early 2000s which got nowhere.

As much as dealers are trying to get investors to join them in the rending of garments, I’m not persuaded this reduced liquidity is a problem, and refreshingly, regulators don’t seem to be intimidated either. But if it sticks (as opposed to dealers going further than they need to for effect), the effects, even on the supposedly disadvantaged investors, would likely be mixed and arguably salutary.

Regulators and economists believe that there was too much liquidity prior to the crisis (or as Claudio Borio and Petit Disaytat put it, too much financial elasticity) and it suddenly dried up. But investors came to see the then so-called “wall of liquidity” (which we now know was due to the operation of leverage-on-leverage vehicles like CDOs) as normal and something they could rely on. Even though they knew intellectually (and hopefully from experience) that markets could seize up and that the summer of 2007 had the smell that the good times were ending, too few were willing to lighten up their exposures. Some of it was inertia, but a lot of it was bad incentives. Hedge fund managers post monthly net asset values; both hedgies and other fund managers are measured against benchmarks, and too many were worried about lagging their peers by getting out too early than protecting investor capital. As Keynes said:

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.

So the danger to investors isn’t a lack of liquidity as much as it is sudden and dramatic changes in liquidity. When I was a kid on Wall Street, the corporate bond market, even with the changes in behavior resulting from the shock of interest rate volatility, was still largely a buy and hold market. Investors might act on a dealer idea or attractive-looking trade but they weren’t into portfolio churn since the transaction costs (bid-asked spread) was recognized as meaningful enough to deter frequent trading. So regulators really are making markets safer if they succeed in widening spreads on an ongoing basis. Lowering peak liquidity reduces the degree to which investors are whipsawed in the event of an unanticipated seize-up. And investors will be less inclined to play as cute as they did in runup to the crisis and hold their positions to eke out the last bit of profit potential. They’ll be forced to think hard about putting on large bets, since exiting them won’t happen as quickly or easily and they’ll also need to execute significant changes in portfolio strategy over a longer period.

Regulatory interventions (higher capital levels, Dodd Frank restrictions on prop trading) may also be a safer way to lower excessive liquidity than transactions taxes. The big trouble with transactions taxes is how to set the level for various products. It’s guaranteed that no matter how you set them, the charges for some products will be too high and others will be too low (which in turn will lead to regulatory arbitrage to make more activities fit into the bucket of the low-transaction-charge product). We’ve seen analogous problems with risk-weightings under Basel II (and the gaming of Basel II was a large, direct cause of the financial crisis). Higher capital rules and regulatory restrictions will hit individual dealers differently due to variations in their market positions and cost structures, which means they also won’t respond identically (for instance, all firms trying to shift all activities to “cheap” products). So a variety in internal shifts is also pro-safety (greater diversity means more robustness).

And amusingly, the investors that will need to make the greatest behavioral changes are the ones with the biggest funds, since larger funds need to execute larger trades to shift their fund’s position. So no wonder Pimco and Blackrock seem particularly unhappy. Couldn’t happen to a nicer bunch.