I am wondering how long it will take for the global authorities to work out that their regulatory regime has made conditions in financial markets worse – someone told me once there is nothing more dangerous that ill-thought our regulation and I think we might be seeing that play out in markets.
We have been having liquidity events for almost a decade now in one form or another but last week the stakes were raised quite significantly went the US repo market went into meltdown, along the way creating yet more problems for the FX markets. I firmly believe that certain regulators and market participants need to face up to this growing problem – we have created an environment in which the (milli)second something unusual happens, liquidity disappears. This is not healthy for anyone and while to date the events have largely hurt speculators that few really care about – they go in knowing the risks – the latest affected the funding markets that fuel the financial system.
I am sure that most of you are aware that a confluence of tax payment day in the US and the maturing of a large Treasury Bond drove the withdrawal of large amounts of cash from the system and saw repo rates in the US jump from 2% to 8% and then back again as the Federal Reserve Bank managed to create and then settle confusion over whether it would fund the market or not (it did – in huge fashion – for the next three days). The apologists for the regulatory regime argue this was an unexpected one-off that does not reflect real conditions in the market. This being a family publication I feel constrained in my response, so let’s go with “nonsense”.
It’s not as though we didn’t know it was tax day or this was happening in the Treasury market – just as last year it wasn’t as though we didn’t know it was Chinese New Year, but that was still blamed for a (minor) blip in markets at that time. This just highlights to me how fragile markets are – even though we know something is happening, just a small element of surprise creates an overblown response.
Over the past two years I have been asking questions of panellists at our events about the challenge of liquidity in forward markets – I will do so again this week at Forex Network Chicago – and while there has generally been a reluctance to openly admit to a problem, I will keep on asking, not least because I’m convinced it exists. I am often told, when discussing market structure change in FX swaps, that it doesn’t need to change because the customers are fine with how the landscape sits. That is fair enough when we are talking pricing in normal circumstances, but how would those customers go if the LPs themselves were struggling to cover exposures?
I was talking to a friend in the FX swaps broking market last week and the picture they painted was not that good. Absolutely volumes are going through the market and things are good on the revenue side, but – and this is a big but – my friend observed that the market is increasingly fragile and that too frequently prices just disappear. To put it in market parlance, “You hear ‘off’, ‘off’, ‘off’, ‘off’, down the lines and you know something has happened” as my friend described it. In other words, something that could create uncertainty emerges and the first instinct is to step back from any liquidity risk you may have in the market in the form of a price. This is, to a degree, what some regulators want – for them it is all about protecting the institution and that means no unnecessary risks, but what about the vital risk absorption function that these institutions should provide if we are to have a healthy market?
There is nothing quite so contagious as a financial panic, as we saw last week when a key interest rate was quadrupled in moments and liquidity disappeared out of every other market. In the FX swaps market last week prices simply disappeared while the confusion reigned, which meant an institution who may have been working out of some risk taken from a client, was suddenly horribly exposed. Is that going to encourage that institution (and that dealer) to work as hard for the client next time? We seem to think that markets can exist in an ‘on-demand’ fashion where people just ask for a price and it exists – that isn’t how it works if no-one is taking a risk somewhere because that price can swing about wildly and then it becomes a matter of timing and luck. That sound like an ”efficient and robust market” to anybody?
Something else that worried me about liquidity in the same conversation with my friend is how an old friend in not only back, but spreading. We all know about quarter end liquidity problems, I have written about them before and again wonder how we got to the stage when such a phenomena exists in supposedly “efficient and robust markets”, but this is rapidly becoming a month-end problem – in other words we have the issue on 12 occasions during the year, not just four. This will create problems for clients again, unless the bank is willing to run risk over a month end, and it doesn’t sound like they are, or will.
I will briefly digress outside of my comfort zone by wondering what last week’s events, and potential month-end chaos on a regular basis, means for the post Ibor markets? I have written before about some very knowledgeable and senior peoples’ concerns over the lack of a curve in a world in which everything is priced off an OIS, if that market is suddenly given to big moves where does that leave us?
Going back to my comfort zone – opinion – there is one sentiment that comes up more and more in my conversations. Regulation was meant to make the world better and safer. It hasn’t. In fact it could be argued, especially if we see a regular repeat of last week’s carnage, it has made it worse. In those circumstances the world needs a brave, resourceful and knowledgeable body to make the call – ‘this isn’t working, what do we do now?’ If that body does have the aforementioned characteristics it will acknowledge that the answer is not more regulation.