Blame Wall Street Dealer Retreat on Lower Risk, Flash Trade

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Wall Street dealers should blame their financial-crisis hangovers and high-speed traders for the decline in their balance sheets, not just government regulations, Federal Reserve Bank of New York researchers say.

The rise of high-speed electronic transactions among investors, dealers and proprietary trading firms has probably shrunk bid-ask spreads, according to a blog post Friday from the New York Fed. That makes it less profitable to trade Treasuries and reduces the need for large balance sheets, according to the research. And because the sharpest drop in risk-taking followed the financial crisis, it isn’t clear to what extent new regulations are the trigger, the analysts said.

“Business-cycle hangovers (the hangover from the housing boom and subsequent risk aversion) and secular trends (electronification and competitive entry) should be considered alongside tighter regulation in explaining stagnating dealer balance sheets,” the analysts wrote on the New York Fed’s Liberty Street Economics blog. It was the last of a five-part series on market liquidity.

The report comes during a debate about whether regulations are putting the financial system at risk by making it tougher to trade debt. The discussion has intensified since a 12-minute, 32-basis-point gyration in Treasury yields in October that happened with no clear driver.

‘Warning Shot’

Dealer inventories dropped by 27 percent from 2007 to early 2015, while assets held by bond mutual funds and exchange-traded funds almost doubled, according to data from Bloomberg, the New York Fed and the Investment Company Institute.

Bank executives have warned about liquidity: Jamie Dimon, chief executive officer of JPMorgan Chase & Co. said this year that the Oct. 15 swing was a “warning shot.” But regulators say the system is safer, and Krishna Memani, chief investment officer of money manager OppenheimerFunds, said Wall Street is only warning about liquidity in hopes of rolling back regulation.

New financial regulations “may help explain the moderate deleveraging since 2010,” the New York Fed, which acts as a supervisor for Wall Street banks, said in its post. The rules from regulators in Europe and the U.S. include capital requirements that bank executives say restrict Wall Street’s ability to act as intermediaries for fixed-income trades.

Even so, “it is unclear to what extent regulations constrain growth in dealer leverage and risk-taking today, over and above a lingering lack of risk appetite,” the analysts wrote.

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