Are we entering a new paradigm for financial markets, one in which liquidity is no longer a given?
It could well be that way.
Last month, SEC chairman Mary Schapiro announced that the commission is considering charging high-frequency traders for cancelled trades. High-frequency traders cancel, on average, 95% of their orders as they react to changes in stock prices, and they are largely blamed for May 2010’s flash crash.
However, brokers say that fees on cancellations will stop high-frequency traders being aggressive and will discourage them from trading – severely reducing liquidity in the equity markets. High-frequency traders account for as much as 70% of daily trading volumes in US equities.
On the corporate bond side, liquidity is also an issue. Inventory of US corporate bonds at US broker/dealers is at nine-year lows– in part as a reaction to the proposed Volcker rule, which prevents banks holding securities for their own book, meaning they are less willing to buy bonds unless they are sure they are placed with customers.
The illiquidity means it is more costly for smaller borrowers to tap the markets, and issuance has already slowed. Basel III requirements are also curbing bond inventories.
Financial markets face much-reduced liquidity at the hands of regulation, and regulators are finding themselves under increased criticism for moving the market in that direction.
But is it so bad? Well, it’s not great. Economies around the world are trying to jumpstart growth, and illiquidity and its consequent rise in costsfor companies wishing to raise capital will dampen that. Banks are naturally critical as they will be forced to increase costs or make less money with less trading activity and bond issuance.
However, is liquidity as critical as the naysayers purport? Probably not. If it’s a level playing field of reduced liquidity in bond and equity marketsthat affects everyone, then the new environment is one that will be different and market participants are certain to adapt.
They are smart, after all, and are driven by money. Already, bankers are talking about new productsand derivatives that might ease illiquidity.
Something had to change and these regulations seem to offer some solution. Will they eliminate market risk? Of course they won’t. And even if they do, some other product or market will crop up that will, down the line, cause another financial crisis.
Less-liquid markets aren’t the end of the world, even though for some financial markets participants it feels like it.
For more in-depth news and analysis on regulation and banking, check out the March issue of Euromoney magazine.
