Nov 17, 2014

Bank Regulation & Market Liquidity: Where are we Five Years Later?

As the annual G20 Leaders’ Summit fast approaches taking place next week in Brisbane, Australia, we pause to consider what progress has been made in terms of a regulatory framework to reform the global financial markets.

In this blog Udi Sela, VP of the Numerix Client Solutions Group reflects on the objectives originally set forth, and the business impact bank regulation has had on market liquidity. Udi examines both sides of this debate discussing how banks and investors have adapted.

Weigh in and continue the conversation on Twitter @nxanalyticsLinkedIn, or in the comments section.

Video Transcript:

Jim Jockle (Host): Hi welcome to Numerix Video Blog. I’m your host Jim Jockle. Joining me today, Udi Sela from Numerix, FX Expert, Udi how are you?

Udi Sela (Guest): Very well, thank you for having me Jim. Good to be here.

Jockle: Thanks for joining us. So, we’ve just passed mid-term elections here in the US where we’ve seen significant changes in terms of the Senate and House. As well as we have the pending G20 Summit, coming back off the heels of the original call for global derivatives reform. And yet, we’re now back in the state of flux, in some way, with pending changes or lack of change into market infrastructure.

One of the things I wanted to talk about today with you Udi, there was a great article that came out in Businessweek, and it said “Big bank rules kill liquidity, Volcker Frank respond.” This was in Businessweek, October 20th, and the basic premise of this article is talking about how the rules and Volcker Rules and elements of Dodd Frank were handcuffing banks. If you could give us a brief summary of some of the topics covered in this report.     

Sela: Yes sure, with pleasure. So basically what we read in this article is, there is an on-going debate whether the regulations that have been restored since the subprime crisis, the various components of the regulation; have they made the market more secure?

And, is it at the cost of actually hampering liquidity, and as a result increasing volatility in the market–which is not necessarily good for the small investors, that regulations were set in the first place to protect.

So that’s basically the two sides portrayed in this article. Some claim, that given the lower appetite for banks for risk, are coupled with the higher costs in terms of regulatory capital for holding positions, has basically, in some cases eliminated or limited the capacity of banks to make markets. And basically, as a result, in market situations where everyone was selling stocks or buying government bonds, price gaps were observed and the ability of investors to trade was severely damaged.

Investors, typically hedge funds investors and portfolio managers, have claimed that this (the price gapping) reduced liquidity hampered their business. Other people say that, in fact, specifically taking the example of government bonds, one of the ways to quantify how liquid the trading is, is to measure in terms of how many days would it take to mitigate the overall government bonds position, typically the US, where at the height of the suffering crisis, this was measured in over 500 days, and since then we’re seeing an average of 300-450 days (required to unwind an entire government bonds portfolio).

So these people say that actually that it’s not true, that liquidity was hampered. You can argue against that, actually looking at government bonds, which indeed the US government bonds are the most liquid financial asset in the world, is that necessarily the asset you want to quantify, or is it just stocks, or CDS’, etc. or foreign exchange contracts. (In other words, the liquidity of US Government bonds, remained intact, but liquidity in other underlying assets was hampered).             

Jockle: One of the questions that you make me think about is running up to the global financial crisis, the markets were so flushed with cash. So regardless of the fact that there was this innate sense that some of the products that were being invested in were risky and that there were different elements of bubbles starting to show. It was that the markets had to put their money somewhere. Are we starting to see that same dynamic today, where investors are really in search of yield?

Sela: My personal view is absolutely, yes. I think that at this time we are starting to see bubbles, such as, or if you like, financial assets price distortions. So look at the yields, for instance, of Euro-Denominated Bonds. It is quite surprising, let’s put it this way, for instance in France, the government bond yields are about half of the yield of the US bonds for the same period, or of the UK government bonds. Which is kind of surprising if you quantify the economic state and even the un-employment market, the prospects, and so forth.           

Also, you can even look at the real-estate prices. For instance, the prices were just published last week that the real estate prices in London went up in the last 12 months by 20%. Obviously the salaries, or if you like, CPI’s, did not go up as much. So yes, I do think there is a bubble, I think although the US, or if you like the Fed has announced that it’s stepping out of the QE (and thus the distorted form of long term US yields may correct, as a result).

Actually, Japan has increased the amount of quantitative easing, so we’ve seen, of course, the yen weakened by an additional five yen or 4.5%. And, currently the rates in Europe are maintained at 0.05, basis point basically so yes I definitely think there is a bubble and a price distortion.  

Jockle: And then additionally, we’re starting to see some easing on lending. So one of the elements of Dodd–Frank, and even in conversations with the BCBS, is the re-introduction of securitization back into the market. We are seeing upticks in CDO’s and other securitized products which allow banks to take elements off balance sheets and free up some lending, so we will probably start seeing liquidity filtering down a little bit more to the individual investor. Hopefully we won’t see over increased leverage on individual balance sheets. It seems like a lot is moving and as we are hitting particular milestones and timeframes, the de-risking of the industry is working, but at the same time the ongoing need for functional markets still exist.

Udi, I want to thank you so much for joining us today and giving us a little bit of light into the issues of liquidity in the marketplace at this point in time, definitely would like to follow-up with you again as it relates to different elements of bubbles that are popping up, that you particularly mentioned. But I think as we’re coming into the year end for 2014, there will definitely be some more interesting conversations around the G20.  I want to thank you for your time today, sir.

Sela: Thank you, Jim and of course we’ll see it will be interesting to see the effect of the mid-term elections on exactly those topics.

Jockle: Excellent. Well, again, we always want to talk about the items you want to talk about. Please feel free to follow us on Twitter @nxanalytics as well as on LinkedIn, where we regularly post and if you have any feedback for us let us know. And Udi, we’ll see you next time.

Sela: Thank you very much, goodbye.

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