A menace is stalking Wall Street. It could induce a global panic. It could send trillions of dollars in wealth evaporating overnight. It could even precipitate the next great financial crisis, warn the likes of JPMorgan CEO Jamie Dimon and former Treasury Secretary Larry Summers. Their bugbear: bond market liquidity.
A combination of market forces and low-interest monetary policy has driven masses of investors into government debt and the $3.7 trillion corporate bond market. But Wall Street is trying to convince regulators that when the herd inevitably stampedes to sell -- likely following an interest-rate increase -- there may be no one willing to buy.
Economists call it an illiquid market: Institutional investors, including retirement funds and insurance companies, struggle to find willing buyers when they want to sell. If the appetite for bonds suddenly dries up, the problem could intensify, bringing huge losses for ordinary investors.
Regardless of whether a liquidity crunch would amount to just another market swing or spur a wider economic crisis, bankers are playing up their fears to angle for looser regulations.
Later this week, a group of bank representatives and asset managers will quietly meet to discuss challenges in the bond market with the Financial Industry Regulatory Authority, or Finra, Wall Street’s self-funded regulator. Among the requests: leeway in reporting rules designed to make bond trading more transparent.
Bond dealers are hoping that they can delay how long they have to report trades to Finra’s Trade Reporting and Compliance Engine, or Trace, from the current 15 minutes to one day, the Financial Times reports.
If they get their way, banks could see a windfall, with ordinary investors footing the bill. Research shows that Trace, implemented in 2002, reduces trading costs for ordinary investors. But participants say it has also helped to drive away market-makers -- big banks that are willing to buy in huge quantities and supply liquidity when needed.
“The cost of transacting clearly has gone down,” says William Maxwell, professor of finance at Southern Methodist University. “That had to come from somewhere, and it was the dealers.”
Predicting a coming crisis, the dealers are fighting back. The little-noticed campaign highlights the ongoing tensions between financial reforms geared toward increasing transparency and industry players grappling with a new normal in markets.
A Painful Crossroads?
Those who hawk debt aren’t the only ones raising alarms over market liquidity. The Bank for International Settlements, the Bank of England and the research unit of the Treasury Department have each amplified warnings around bond market stability. In addition to an eventual interest-rate rise from the Federal Reserve, investors worry that turmoil in the eurozone could spark a bond rout.
Financial reforms have helped changed the game. Before 2008, investment banks acted as the de facto market-makers in bonds. They bought and held vast quantities of corporate debt, and usually they could be counted on to buy when investors wanted to sell.
But post-crisis capital rules forced big banks to stock up on cash reserves and trim their liabilities. These regulations, routinely attacked by the banking community, meant that financial firms couldn’t load up on bonds quite like before. Major bond dealers now hold less than one quarter of the corporate debt they held in late 2007.
Though banks have complained for years about capital rules crimping their bond-trading profits, their protests have mounted lately. Most recently, HSBC chairman Douglas Flint joined the chorus. “We wanted banks to shrink their trading operations and they did,” Flint said Tuesday. “Now we’re worrying about how much more liquidity is available to long-term investors for their illiquid assets.”
The banks warn that a full-blown run on bonds in the current environment could spell catastrophe. JPMorgan’s Dimon devoted a substantial portion of his annual letter this year to imagining such a crisis. It would be, he wrote, “harder for banks, either as lenders or market-makers, to ‘stand against the tide.’ "
Investors, too, are feeling the pinch. Portfolio managers looking to offload bonds sometimes wait weeks for a deal to go through, and institutional investors have already begun shuffling their decks.
“We used to have these big pipes that flowed from all of the clients through the dealers,” says Ian McAllister, chief financial officer of the bond-trading platform Electronifie. “Now the pipes aren’t wide enough to deal with the volume, even in normal times.”
But some have their doubts that these liquidity concerns rise to crisis proportions.
Jim Vogel, executive vice president of FTN Financial, says bond market volatility -- a proxy for measures of liquidity -- is about normal on a longer historical time frame. “We’re not yet in the camp that says trading liquidity is dooming us to a painful crossroads,” he says.
“A lot of the time periods we look back and say, 'Oh those were really liquid markets,' ” Vogel continues. “But we don’t see that much difference today.”
A Rational Reaction
Unlike capital requirements, the bond-trade reporting rules that are expected to be discussed at the upcoming Finra meeting have only recently entered the industry’s crosshairs.
Before Trace came into effect in 2002, bond trading was opaque and cliquish. A handful of Wall Street banks made up the major dealers. Since prices weren’t publicized, institutional investors often couldn’t know whether the deals they hashed out over the phone were bargains or rip-offs.
With Trace’s arrival, the costs of bond trading dropped. Since investors could now see prices essentially in real time, they could demand better deals from big dealers.
Banks haven’t been thrilled about the system, especially as revenues from fixed-income -- that is, bond trading -- continue to languish. Before, a bank would be willing to step in during a sell-off and pick up cheap bonds. In the absence of price disclosure, a batch bought at a discount $80 could be resold for $90 without raising hackles. But with Trace in place, investors cry foul at steep mark-ups.
Still, bond sale reporting issues persist. Last year, Finra fined some of Wall Street’s largest institutions -- including JPMorgan and Citigroup -- after finding thousands of lapses in their Trace reporting. Traders can gain an edge by withholding new price data.
But the availability of up-to-date price data hasn’t changed who holds sway in the bond market. A few major banks still control most bond trading activity, despite the emergence of upstarts like Electronifie that attempt to connect investors in order to trade bonds directly with each other.
With big banks committing too little capital to keep the market running smoothly, investors are torn between living with a market most agree has serious defects and surrendering the transparency that keeps transaction costs down.
Maxwell, who has studied the impact of reporting requirements on the bond market, says easing the requirements might help ease liquidity concerns by giving banks more reason to trade. “In the end, they’ve got to make money or they’re not going to make a market,” he says. “It’s a rational reaction.”
But what's rational for the banks could cost investors. "How much transaction costs will go up, I don’t know," says Maxwell. "But they will go up."