Conflicting bank safety rules may be reducing U.S. bond market liquidity, a witness from the securities industry told a U.S. House panel Friday.
Randy Snook, an executive vice president at the Securities Industry and Financial Markets Association, appeared at a hearing on the structure of the fixed income markets organized by the House Financial Services Capital Markets Subcommittee.
He gave the requirement that banks hold a minimum level of high-quality liquid assets as an example of a well-intentioned rule that could backfire.
The highest-quality liquid asset category includes securities issued by the U.S. government, or guaranteed by the U.S. government.
When dealers scoop up high-quality liquid assets to meet new standards, that cuts down on the supply of high-quality liquid assets available for purchase, and the dealers than have to add higher-yielding collateral to compensate for the burden of holding all of those high-quality, but very low-yielding, liquid assets, Snook said.
The constraints may reduce banks’ interest in operating in the bond market, especially in times of stress, Snook said.
Principal trading firms, or firms that specialize in buying and selling bonds, may help make up for the banks that back away from the bond market, “but market depth has become more fleeting in general,” Snook said. “Moreover, less diversity in liquidity providers leads to less resiliency, particularly during stress periods.”
The U.S. Securities and Exchange Commission developed municipal securities market disclosure rules that are set to take effect in May 2018. The rigid procedures required by the rules could chase dealers away from municipal bond market and hurt liquidity in that market, Snook said.
Another witness, Alexander Sedgwick, who appeared on behalf of T. Rowe Price Associates Inc. and the Investment Company Institute, said simply determining how bond market liquidity has changed is difficult, and that it’s hard to separate the effects of regulations from the effects of low interest rates and other market conditions.
Commonly used measures paint a mixed picture of the state of liquidity in the Treasury market, Sedgwick said, according to the written version of his testimony.
In the market for corporate bonds, activity is high, and consistent, for the 1,000 most actively traded, big-name bonds, and much lower for other bonds, Sedgwick said. He said he believes liquidity probably has fallen for corporate bonds from lesser-known issuers.
Before the Great Recession, broker-dealers kept large amounts of fixed-income securities on their shelves, to help customers make trades quickly, without having to wait for counterparties to come along, Sedgwick said.
Now, Sedgwick said, in part because of regulatory constraints, many dealers simply want to match buyers with sellers, without holding much inventory themselves. He sees the dealers’ bare shelves leading to some loss of liquidity.
Meanwhile, Sedgwick said, low interest rates are leading some corporations to issue bonds for the first time. Even though bonds from big-name issuers, which appeal to institutional investors, may trade about as well as ever, many of the bonds from the newer, lesser-known issuers are likely to be illiquid.
Regulations might be causing some of the drop in liquidity, but, if rates rise, the amounts dealers can earn from helping with bond deals might grow, and that could lure some market makers back into the bond market, he said.
Rising rates could also increase the appeal of secondhand bonds, he added.
In recent years, Sedgwick said, many corporations have been eager to take advantage of low rates by issuing new bonds. Institutions have had an easy time buying bonds directly from the original issuers.
“The flood of new supply made secondary trading less essential,” Sedgwick said. “However, if rates start to rise and companies became less keen on raising new capital in the credit market, we expected renewed focus on secondary market trading.”
Copies of the written testimony and other documents related to the hearing are available here.
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