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Trump Team's Worries About Bond Liquidity Are Too Late

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(Bloomberg Gadfly) — It’s almost antiquated that newly minted regulators are ramping up their bond-market liquidity worries now.

Traders already spent years fretting about a logjam in debt markets, back in 2013, 2014 and 2015. But many people have tired of thinking about it, especially because trading volumes have generally been increasing and Wall Street firms are profiting.

(Related: Hedge Fund Invasion of U.S. Treasuries Puts Bond Traders at Risk)

Now, however, the Financial Stability Oversight Council is reviving the issue just as President Donald Trump’s Treasury secretary, Steven Mnuchin, gets his bearings. This watchdog group is studying whether post-crisis regulations are causing financial instability rather than preventing it, namely by diminishing the extent to which Wall Street banks can facilitate debt trading, according to a Bloomberg News article by Jesse Hamilton and Ben Bain. In February, Trump’s chief economic adviser, former Goldman Sachs Chief Operating Officer Gary Cohn, raised similar concerns.

The crux of the issue is that post-crisis regulations forced big banks to reduce the amount of riskier assets they held. That included those held for proprietary trading as well as those used to make markets by buying large chunks of debt from clients and then slowly selling them over time. By many accounts, this has made it more difficult for investors to trade different types of dollar-denominated debt in large pieces quickly and without moving markets.

Regardless of how substantial bond-market liquidity threats are to financial stability, this study is years too late. At this point, banks and investors have generally adapted to the current environment. To the extent traders are still concerned, they hold more cash, use derivatives, turn to electronic-trading systems or plan to hold assets for longer. To the extent banks lament the fat profits of yore, they’ve jettisoned traders accustomed to multimillion-dollar bonuses and changed the way they do business to match buyers and sellers.

Even if the regulatory group were to recommend a complete rollback of all financial regulations adopted since the 2008 crisis, it’s unclear how quickly banks would reprise their role of taking substantial risk to facilitate trading, or if they would at all. The world has changed. While many agree that bond trading is evolving and still needs improvement, there isn’t enough desire to shift the model back to what it was before the crisis.

And it turns out that bond trading can still be lucrative for large banks, even with much less risk. The goal is to rack up enough volume to generate substantial profits, regardless of the fact that each trade is less profitable than in the past. At this point, the biggest lenders employ traders with more experience matching up buyers and sellers than deciding how to take risks, like the star traders of the past. (Those traders largely decamped to hedge funds, with mixed results.)

Big Wall Street firms would undoubtedly love to spend less on compliance. Some may even welcome a return to using their own money to trade, although it’s unclear to what extent. But the bond-market liquidity worry train has come and gone.

— Read PIMCO’s El-Erian Asks: What’s Happening to Bonds and Why? on ThinkAdvisor. 


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