Financial regulators witnessed some of the world’s most actively traded markets fall into a steep slump earlier this year. Despite the reforms instituted in the wake of the 2008 crisis, global bond trading fell sharply and remained well below expectations. Many analysts attributed this to a liquidity crunch that has the potential to cause another downturn.
This month, the Global Financial Markets Association and the Institute of International Finance commissioned a report on the state of liquidity in global bond markets. The report, authored by PricewaterhouseCoopers (PWC), claims that the regulatory overhaul that occurred after the financial crisis has been the main contributor to the decline in bond market trading. The authors claim that many global financial regulations, including the Dodd-Frank Wall Street Reform and Consumer Protection Act, the European Market Infrastructure Regulation, and the Basel Accords, among other new financial standards, threaten the future of international trading markets. The report’s authors urge regulators to perform a comprehensive review before any further regulations are implemented.
The authors identify five ways regulatory reforms have allegedly reduced liquidity—that is, the ability to make transactions with limited external costs and low price impact. According to the report, banks responded to the overhaul by seeking to make more efficient use of their capital by reducing the markets they serve and streamlining their operations. Consequently, banks raised the amount of capital they kept in reserve and issued fewer loans.
The authors claim also that the onslaught of post-crisis regulations diminished market-making activity (the process by which many people trade securities and manage risk in bond markets) across the globe by raising both the cost of capital and the cost of financing businesses.
Regulations are responsible, the authors argue, for a large shift in general trading patterns away from a platform that institutional investors and corporations traditionally use. These trades—commonly referred to as over-the-counter trades, because they do not depend on public exchanges—have shifted towards centralized clearing and electronic trading platforms. This shift, according to the report, has made liquidity harder to access for borrowers who do not use public exchanges as readily.
The report goes on to claim that regulations have reduced liquidity in short-term loan markets (known as repo markets). Regulations have also created an environment that artificially inflated the value of liquid assets themselves, leading to hoarding and increased demand, according to the report.
Liquidity is necessary for a functioning market because it facilitates the efficient distribution and allocation of resources, capital, and risk throughout the economy. When liquidity begins to dry up, capital becomes more expensive, the cost of executing business transactions rises, and the task of identifying value in the economy becomes more difficult for all. Prolonged periods of low liquidity can be especially problematic by leading to large sell-offs, a run on a bank, or a general unwillingness to engage in trading at all.
The authors of the PWC report call for a broad evaluation of the international financial regulatory framework and identify some considerations for review. They recommend improved market data collection, targeted in part at how regulations affect individual asset classes. They believe that all new regulatory rules should be designed to strike a balance between creating banking sector stability and maintaining liquidity in financial markets. Finally, they recommend a review designed to ensure internal consistency within the body of regulation that covers different rule areas and to confirm that international standards are uniform.
The Global Financial Markets Association and the Institute of International Finance, which commissioned the report, provide analysis and guidance on global market issues, including emerging markets, international banking, and global finance. They are among the many organizations that have attempted to provide standards and guidance this year to combat the slump in bond trading.
Last summer, the Financial Industry Regulatory Authority (Finra) called on a group of bank executives and asset managers to explore solutions to the liquidity crunch. The Basel Committee on Banking Supervision also finalized new criteria recently for “identifying simple, transparent, and comparable” securitizations to support investor confidence and boost trading activity.
Financial regulators often seek to find a balance between bank stability and market activity. As liquidity dries up, borrowers are forced to turn to alternative market-based finance providers that can pose higher risks. The PWC report warns that although global monetary policy has provided support for liquidity, regulators should be aware of “early warning signals” as governments roll back quantitative easing and begin to raise interest rates, which may lead to further economic downturns.
Penn Program on Regulation
University of Pennsylvania Law School
3501 Sansom Street
Philadelphia, Pennsylvania 19104
RegBlog Faculty Advisor
|General inquiries and submissions: firstname.lastname@example.org|
Information for authors
the contents of this div will be replaced
Elizabeth Warren is the senior United States Senator from Massachusetts. Senator Warren has served in the Senate since 2012, and she is the ranking member on the Economic Policy Subcommittee of the Committee on Banking, Housing, and Urban Affairs. She was the driving force behind the Consumer Financial Protection Bureau, and in 2008, she headed the Congressional Oversight Panel for the Troubled Asset Relief Program.
Jason Furman is the 28th Chairman of the Council of Economic Advisers, a role in which he serves as President Obama’s Chief Economist and as a Member of the President’s Cabinet. A member of President Obama’s Administration since the start of his presidency, Chairman Furman previously served as Principal Deputy Director of the National Economic Council and as Assistant to the President.
Jed S. Rakoff
Jed S. Rakoff is a United States District Court Judge for the Southern District of New York. He ascended to the bench in 1996 after being nominated by President Bill Clinton, and he assumed senior status on December 31, 2010. He is a leading authority in securities law and white-collar crime as well as a prolific writer, having authored four books, 100 published articles, over 220 speeches, and over 425 judicial opinions.
Susan Dudley is the Director of the GW Regulatory Studies Center and distinguished professor of practice at GW’s Trachtenberg School of Public Policy and Public Administration. She serves as president of the Society for Benefit-Cost Analysis, and as a senior fellow of the Administrative Conference of the United States. She served from 2007 to 2009 as the Administrator of the Office of Information and Regulatory Affairs within the Office of Management and Budget.
Richard L. Hasen
Richard L. Hasen is the Chancellor’s Professor of Law and Political Science at the University of California, Irvine. A leading expert in campaign finance regulation and election law, he is the author of the book, Plutocrats United: Campaign Money, the Supreme Court, and the Distortion of American Elections, as well as the writer of the widely regarded Election Law Blog.
Wendell Pritchett is the Presidential Professor of Law and Education at the University of Pennsylvania Law School, and he is a recognized leader in the field of higher education. He was Deputy Chief of Staff and Director of Policy under Philadelphia Mayor Michael Nutter, who later appointed him to the School Reform Commission, where he served from 2011 to 2014. He also served as Chancellor of Rutgers-Camden from 2009 to 2014.
Mike Lee is the junior United States Senator from Utah. He is the Chairman of the Senate Steering Committee; the Judiciary Subcommittee on Antitrust, Competition Policy and Consumer Rights; and the Water and Power Subcommittee of the Energy and Natural Resources Committee. He was previously General Counsel to Utah Governor Jon Hunstman, and law clerk to Supreme Court Justice Samuel Alito.
Patricia L. Bellia
Patricia L. Bellia is Notre Dame Law School’s William J. and Dorothy K. O’Neill Professor of Law. A teacher and researcher in multiple areas including constitutional law, administrative law, and cyberlaw, Professor Bellia is co-author of a leading cyberlaw casebook and has published articles on internet law and separation of powers. She previously served as an attorney-adviser in the Justice Department’s Office of Legal Counsel.
Donald C. Langevoort
Donald C. Langevoort is the Thomas Aquinas Professor of Law at Georgetown University. He was previously Vanderbilt University School of Law’s Lee S. and Charles A. Speir Professor, and the U.S. Securities & Exchange Commission’s Special Counsel in the Office of the General Counsel. An authority in the area of securities regulation, he is the co-author of a securities regulation casebook and author of a treatise on insider trading.
Rena Steinzor is a professor at the University of Maryland Carey Law School. She is a founder, former president, and member scholar of the Center for Progressive Reform. She teaches and has authored and co-authored books on administrative law, consumer safety, public health, and environmental law. She has testified before Congress multiple times, addressing such issues as the impact of health, safety, and environmental regulations on the economy.
Richard L. Revesz
Richard L. Revesz is New York University School of Law’s Director of the Institute for Policy Integrity and the Lawrence King Professor of Law. From 2002 to 2013, Professor Revesz was the Dean of NYU School of Law. He is a nationally recognized expert in the fields of environmental and regulatory law and policy, with a focus on issues including the use of cost-benefit analysis in administrative regulation.
the contents of this div will be replaced