Wall Street’s complaints that new rules have hurt bond-market liquidity got a boost Monday when a Federal Reserve governor said forcing banks to hold more capital might be discouraging them from facilitating trades.
Though financial regulations “had little to do” with Treasury market volatility last October, they “may be one factor driving recent changes in market-making,” Fed Governor Jerome Powell said at a Brookings Institution conference in Washington. “Requiring that banks hold much higher capital and liquidity and rely less on wholesale short-term debt has raised funding costs,” he said.
The Fed and other U.S. regulators said in a report last month that the Treasury market’s wild swings on Oct. 15, 2014, resulted from many factors, including banks pulling out of the market and high-frequency traders being on both sides of the same trade.
Financial firms have complained that a series of rules implemented under the 2010 Dodd-Frank Act have reduced liquidity in the bond market and exacerbated price swings. JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon has said what happened in October should serve as a “warning shot” to investors, and Blackstone Group LP CEO Stephen Schwarzman has said that new regulations may fuel the next financial crisis.
Powell said banks should be prepared to accept some increase in the cost of market-making since regulations have lowered their likelihood of default and the chances of another financial crisis. Regulations have also raised the cost of funding inventories through repo markets, he said.
“Although the Treasury market remains deep and resilient, there are nonetheless reasonable questions as to whether market functioning can be improved,” Powell said.
He also said that anyone can be a speed trader and trade at high frequencies. He said that the Fed, foreign buyers and asset managers have increased their ownership of Treasuries in recent years.
In a question-and-answer session after his speech, Powell said “the story is way more complicated than the ’Flash Boys’ story,” referring to the Michael Lewis book critical of high-frequency trading.
Powell said it’s reasonable to expect more volatility in financial markets as the Fed prepares to raise interest rates for the first time since 2006, but not every market reaction has important implications for the real economy.
The Treasury market will be the topic of a conference that regulators hold Oct. 20-21 at the New York Fed, Powell said.
Antonio Weiss, counselor to the U.S. Treasury secretary, said at the conference Monday that regulators need to assess how new trading algorithms are set up, figure out how to look at risk across Treasury markets in real time and to study the kind of self-trading that contributed to liquidity problems last October.
“We need to consider whether the race for speed, at this already advanced stage, helps or hurts market functioning,” Weiss said. Many of the big, new traders aren’t subject to oversight “and may not be sufficiently capitalized to withstand unexpected losses,” he said.
“We cannot get the information we need to analyze risk across Treasury markets in anything that approaches real time, and that has to change,” said Weiss.