Monday, July 10, 2017

Fed Reports Post-Crisis Regulation Affecting Bond Market Liquidity

Affects are real, but do not not point to any substantial impairment in liquidity.

Author: David Schwartz J.D. CPA

In its semi-annual Monetary Policy Report submitted to Congress on July 7, 2017, the Federal Reserve Board indicated that regulatory reforms since the global financial crisis "have likely altered financial institutions' incentives to provide liquidity.”  The Fed found that In recent years, market participants have been particularly concerned with liquidity conditions in the corporate bond market. This concern stems from the tendency for bonds to be traded less frequently and more reliance on dealer intermediation for liquidity provision than in many other markets. Despite these concerns, however, the metrics available to the Fed do "not point to any substantial impairment in liquidity in major financial markets.”


Relying on a range of conventional metrics of liquidity, the Fed found that there have been strains on corporate bond liquidity as a result of regulatory reforms. But these stresses appear to have moderated over the past few years. As a measure of liquidity, the Fed looked at bid-ask spreads in the years just before the financial crisis, and years since. The data shows that the bid-ask measure of trading costs skyrocketed during the financial crisis, but has returned to the range seen before the crisis. In addition, in recent years measures of the effect of trades on prices follow a similar pattern and have been fairly stable. The Fed also noted that "other measures related to factors associated with market liquidity, such as trends in average trade size and turnover, also suggest market liquidity conditions are benign.”


The Fed has been monitoring liquidity in bond and repo markets closely over the years, particularly with respect to the effects new regulation may be having in these areas.  In December 2016, the Fed produced a report that found that “the Volcker Rule has a deleterious effect on corporate bond liquidity and dealers subject to the Rule become less willing to provide liquidity during stress times. While dealers not affected by the Volcker Rule have stepped in to provide liquidity, we find that the net effect is a less liquid corporate bond market.” In a January 2017 report, the Fed also found "that regulations limiting banks’ balance sheets like the Supplementary Leverage Ratio have made repurchase agreements (repos) more expensive for dealers, and this, in turn, has had negative effects on liquidity in the cash Treasury market.”


The full text of the Fed’s July 7, 2017 semi-annual Monetary Policy Report is available at: