Fed's Dudley Downplays Market Liquidity Concerns, Eyes HFT

Federal Reserve Bank of New York President William Dudley in a speech Wednesday pushed back against assertions that new rules are damaging trading conditions in the $40 trillion U.S. bond market, but said regulators should be open to altering rules if it could address investors' concerns without sacrificing the safety of the financial system. In prepared remarks before the Securities Industry and Financial Markets Association, a Wall Street trade group, Mr. Dudley said he didn't think investors' hypothesis that rules were the lead cause of changing liquidity conditions in the bond market was well-supported by the available evidence, calling that evidence "at best mixed." Even if it were the case that rules had hurt the ease of trading in and out of bonds, he said, such a trade-off had to be weighed in the context of those same rules having creating a sound financial system that may be better insulated against future financial crises. At the same time, Mr. Dudley conceded that if there were a better balance that could be achieved between the impact of new regulation and improved trading conditions, he was open to finding it, a compromise likely to be warmly welcomed in Wall Street circles. "We certainly don't want to undermine the progress we have made in making the financial system more robust and resilient," he said in the keynote speech. "But if there are adjustments to regulation that could improve liquidity provision without increasing financial stability risks, we should be open to considering such changes." Such a determination, he said, would require a lot more data, analysis and research "before we reach any definitive conclusions," he added. Before joining the New York Fed in 2007, Mr. Dudley was a partner and managing director at Goldman Sachs Group Inc. Rules enacted in the wake of the 2008 financial meltdown constrained the ability of large securities dealing banks to take risks, and forced them to set aside enough capital to cushion themselves against future shocks in the market, making it harder for them to act as middlemen in bond trades. Some banks have exited or drastically reduced their participation in parts of the bond trading business as a result. Ever since, a chorus of investors has complained about having to pay more to transact, and that trades can no longer be completed as easily in large sizes, without moving market prices. Mr. Dudley's remarks come as Federal Reserve officials, himself included, are signaling that they are close to raising short-term interest rates for the first time in nine years. Low rates have delivered strong returns for bondholders for three decades in a row, but when rates rise, existing bonds are expected to become less attractive because new bonds can be issued in their place at higher yields. Some worry large scale selling by investors could trigger turmoil in bond funds, one that would be harder to cushion than in previous years because of many of the ways the financial system and dealer banks have changed since the rules came into effect. Mr. Dudley said the Fed's "unconventional monetary policy may have affected recent measures of liquidity in ways that could make it more difficult to clearly discern any potential changes," adding that if that were the case, "a clearer picture on liquidity conditions may only emerge as monetary policy is normalized." The changing behavior of banks, coupled with a rise in electronic trading in bonds, have driven faster, less predictable moves in bonds. Analysts say trade sizes are shrinking and large trades are becoming more difficult to conduct in reasonable time-frames. At the Sifma event Wednesday, Douglas Peebles, chief investment officer at asset manager AllianceBernstein, said bonds had become harder to trade and, as a result, many portfolio managers are now holding 10% of their funds in cash versus around 2% precrisis. He advocated for a 24-hour delay on trade reporting for market-moving, block sized corporate bond transactions as one potential solution. "There's a variety of different players on the buy side and sell side who agree a 24-hour delay for what could be considered 'big people' trades...would go a long way" to easing trading conditions, he said. The Financial Industry Regulatory Authority has been considering such a delay for corporate bond trades above a certain size. Researchers at the New York Fed have concluded that liquidity is adequate from day to day; the problem is more evident when traders begin to worry about losing their capacity to buy and sell with ease at a future point in time, a concept they have called "liquidity risk." "There is limited evidence pointing to a reduction in the average levels of liquidity. However, there are reasons to think liquidity risk may have increased, and there are some data to support this conjecture," said Mr. Dudley. "If liquidity risk is high, this means that there is a substantial risk that the price received could be at a greater concession to the prior trade than anticipated." Regulators are still learning what the growth in electronic trading and activity by high-speed traders will mean, said Mr. Dudley. But they have been collecting data and considering what additional steps they need to take, including which additional data feeds should be more readily available to them for a faster response to market upsets in future. Mr. Dudley conceded that so far regulators have primarily looked at data only from trades between securities dealers, instead of trades between dealers and their customers. He said that since the Oct. 15, 2014 flash rally in Treasury prices, when yields plummeted within minutes before recovering, price action in the $12.7 trillion U.S. Treasury market had changed, "indicating some deterioration of liquidity, but [that the condition] is still not high relative to its longer-run experience." "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 to return to the liquidity conditions before the financial crisis, but instead" whether there is an increase of liquidity risk, Mr. Dudley said. He added that it would be worth exploring "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." At the Sifma forum, Sandra O'Connor, chief regulatory affairs officer at J.P. Morgan Chase & Co., said one problem is that multiple rules are addressing multiple risks, but in some instances are overlapping. She said changes in the bond markets had caused a smaller trade volume to move market prices. As of this year, $130 million trades in 10-year Treasurys is enough to move prices, she said, versus a post-crisis average of $185 million and $500 million precrisis. One sign of the liquidity impact is rising volatility, she added, noting that there have been more days incurring a 0.10%-plus yield change in Treasurys this year than in all of 2014.