Tuesday, October 6, 2015

Fed Pres. Dudley Addresses Market Liquidity

Author: David Schwartz J.D. CPA

In a September 30, 2015 speech before the SIFMA Liquidity Forum in New York, Fed President and Chief Executive Officer William C. Dudley addressed concerns that market liquidity is being hindered by regulation.  While open to the idea of finding a better balance between new regulations and improved trading conditions, Dudley stated that he found, "the evidence to date that liquidity has diminished markedly is, at best, mixed."  In addition, Mr. Dudley does not find any real evidence that regulations are the primary cause of changing liquidity conditions in the bond and other markets.  

"Some opponents of tougher bank regulation claim that the increased regulatory requirements, such as the higher capital requirements and new liquidity standards, that have been imposed on large financial institutions in the aftermath of the financial crisis have reduced these firms' market-making capacity. As a result, so the argument goes, this is leading to less liquidity for trading securities, and to more illiquidity events in which the prices of financial assets move sharply and become temporarily unmoored from their fundamental valuations. The contention is that higher liquidity costs and more frequent illiquidity events will, over time, drive up the borrowing costs of households, businesses and the U.S. government; and that this is a substantial, largely unintended cost imposed by tougher regulation. Thus, the argument concludes, the regulatory burden should be rolled back.  This is a noteworthy assertion and would have significant implications for regulatory policy if it were correct.  However, as I will lay out in my remarks, I don't think the hypothesis is well-supported by the available evidence."

According to Mr. Dudley: 

  1. The evidence to date that liquidity has diminished markedly is, at best, mixed.
  2. Even if one were to interpret the evidence as indicating that liquidity has been reduced, it is not clear whether regulation is the primary driver, as other changes have played important roles as well.
  3. Even if higher capital and new liquidity requirements were found to result in greater transaction costs, these costs would need to be assessed against the benefits of having a more robust and resilient financial system and a reduced risk of financial crises in the future.

That said, however, Dudley is aware that, because of limits on available data, there is still much that is unknown about current liquidity conditions.

"The available market liquidity data primarily focus on the inter-dealer markets and thus do not shed light on possible liquidity changes between dealers and customers. In addition, the financial system is adjusting in complex ways in reaction to regulatory, technological and other changes. We need to better understand the degree to which any changes in the nature of liquidity reflect the evolving structure of financial markets, changes in regulatory policy or other factors. With respect to regulatory policy, an important objective should be to achieve the best balance between the benefits of increased safety and soundness versus any costs imposed by these regulatory changes on market function and liquidity."

Consequently, Mr. Dudley promised that the Fed would be exploring potential "adjustments to regulation that could improve liquidity provision without increasing financial stability risks."  Before reaching any conclusions, however, he wants more and better data.  

"Only through much more careful study and data analysis can we thoughtfully address the two most important questions—not whether regulation should be rolled back in order to return to the liquidity conditions prior to the financial crisis, but instead:

  • whether there is a diminution of liquidity and/or an increase in liquidity risk that is costly or poses risks to financial stability or macroeconomic performance; and, if this this is the case,
  • whether financial market regulation could be altered in a way that improves the balance between the benefits of tougher regulation in terms of enhanced financial stability versus the costs of such regulation, including any adverse impacts on market liquidity provision. In addition, whether microstructure reforms aimed at improving the functioning of markets could be promising in that respect."