The Last Look…
Posted by Colin Lambert. Last updated: November 29, 2022
Is it time to reassess the post-GFC regulatory world and consider nuancing many of the rules that were imposed more than a decade ago?
Flying home from the UK to Australia at the start of last week I sat two rows in front of a man who coughed and sneezed the entire 20-odd hours and, inevitably, I tested positive for Covid days after. Less than a year ago, a clearly unwell and infectious person would not have been allowed on the flight, but the rules have eased around this and thus, I was probably not the only passenger on QF2 to have a rough end of the week and weekend.
Why do I bring this up? To me it is a handy metaphor for one of the challenges facing financial markets – the impact of regulation and the importance of striking the right balance in how rules are deployed.
I am not suggesting that we don’t need regulation – if the events in crypto show us anything it is that we do – but rather I feel that we have gone on too long with the “blunt stick” approach and now is the time for the authorities to reconsider the impact their initial rules are having.
I am not sure if it was when banks become brokers, or is genuinely the lasting result of the GFC, but until the world understands that “risk” is not a dirty word, we will continue to see and hear of angst in markets over liquidity levels and efficient functioning.
What regulation has, in its entirety, delivered, is a financial markets system predicated upon the “hot potato” model, where everybody wants to be a liquidity provider but few want to actually hold any risk for what would be considered a lengthy period.
The latest round has come in US Treasury markets following the progress report from a group of senior US regulators on market resiliency. This report highlighted concerns and the possible causes and remedies. Inevitably the latter includes a fair amount of self-interest from parties interested in one model or the other, and the causes are clearly manifold. To me, however, the number one cause of liquidity issues in many markets, US Treasuries especially, is the lack of risk in the system.
What regulation has, in its entirety, delivered, is a financial markets system predicated upon the “hot potato” model, where everybody wants to be a liquidity provider but few want to actually hold any risk for what would be considered a lengthy period. Last week saw the G-SIB buckets published and for those banks close to a new bucket, the cost can be significant – which is why we see periods of illiquidity as certain players simply pull back from the markets.
It is no coincidence that we regularly hear of US banks losing ground in the FX swaps market compared to European players, the US firms are simply in front of their European brethren when it comes to the capital impact of regulation. This is a look into the future of the markets, where banks are limited in the amount of risk they hold and, understandably, hold the reins tight.
At the moment, the authorities are turning their focus to non-bank financial intermediaries – fair enough, this is where a lot of the risk is going at this time, but is extending regulation to this sector really the answer? The fact is, different institutions have different roles to play and for banks, with their strong balance sheets, it is risk warehousing. NBFIs are largely interested in churning flow and taking a piece of the action on the way through – they are the true brokers out there, and they have a role to play, it’s just we really don’t need banks operating in the same fashion. The problem is, regulation is forcing them to do so.
The unintended consequences of regulation is a college degree subject in its own right, of course, and here I suspect one consequence is actually nullifying another hope of the regulators – more transparency.
Think of it in this way. If I am a trader willing to take on large risk and hold it for a period of time, who do I want to know about it? The fewer people the better. Therefore, I offer that liquidity through private channels so that the least number of people possible know about it. The trade is not published on a public venue for all to see, I can hold the risk I wanted to take, without fear of someone trying to squeeze me deliberately (GameStop anyone?)
The upshot of this, of course, is that a large proportion of the now-limited capital I have at my disposal is dedicated to these opaque channels, meaning I am going to price less in a public environment, hence, liquidity in these places is going to deteriorate.
Along with the problem of risk being viewed as something to avoid, I also suspect there is a view in the world that there is always a matching trade available. This is pure nonsense and is propagated by people with an interest in the all-to-all, totally transparent, model. In the past there was always a price available, but it was not necessarily a match – the price maker was going to hold that risk for a period of time. Now, the ability to hold that risk is diminished.
Conditions are, effectively, demonstrating what happens when you take genuine risk out of the system by making it uneconomic to provide such services.
To me, just as the world undervalues genuine liquidity providers, it vastly undervalues risk warehousing for more than a few seconds and that is where we need to revisit the rules. The US Treasuries market is touted as the world’s deepest, most liquid, market, but there are clearly problems there and they have largely raised their head since the imposition of the post-GFC regulatory agenda. Conditions are, effectively, demonstrating what happens when you take genuine risk out of the system by making it uneconomic to provide such services.
I should stress that I am not for one moment advocating very light regulation, but more that what we have now is overly-stringent and is hampering market functioning. This needs to be recognised by the authorities and the rules looked at. By all means provide strong rules around business and financial transparency, but use this to monitor for risks in the system, rather than heaping more charges upon charges to cover the next catastrophe (and by the way, there is a really good chance that the resources will still be too limited to cope).
Lots of us fly because it is an integral part of our business and the pandemic has highlighted that while we can function as a market (and a world), there are still times when you need to sit in front of someone. To me, it seems sensible that – in the case of airlines – it would be a sensible precaution still to require a negative Covid test before flying (and the airline has to be flexible in re-booking of course).
In markets, we need to understand that while we do indeed need visibility over the financial health of our major institutions, we should not handcuff them by making it too expensive to do the job they were actually invented for in the first place.