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Paper tiger

18 June 2015 By Antony Currie

Trading illiquidity is the bugbear du jour for Wall Street and the City of London. Blackstone boss Stephen Schwarzman is just the latest financial bigwig to argue that the enforced shrinkage of banks’ activities is hurting liquidity so badly, particularly in bond markets, that it could fuel the next crisis. A look at how markets have changed – and how brokers actually behave – suggests otherwise.

The argument, which echoes others’ including JPMorgan Chief Executive Jamie Dimon and Goldman Sachs No. 2 Gary Cohn, goes something like this. New regulations make it too expensive for middlemen like JPMorgan and Goldman Sachs to keep as big an inventory of sovereign and corporate bonds as they used to. That means banks have less ability to step in and buy securities from clients when markets get into trouble.

Data from the Federal Reserve confirm that U.S primary dealers now hold around $50 billion of corporate bonds, down 80 percent from a peak of around $250 billion in 2007. Other information also suggests market depth has decreased – trading volume has increased but the dollar size of trades has fallen – making it harder for bond traders to buy or sell significant blocks of securities without moving market prices. Taken as a whole, the logic continues, this means there’s a newfangled danger of a spiral of selling that could make any crisis much worse.

Brokers are certainly more careful with their capital than they used to be. But the argument has enough holes to let a thousand-year flood through, not least that the trend in the Fed data, at least, largely disappears if the starting point is set in less frothy 2003, say, than at the peak of the U.S. mortgage bubble. Perhaps more importantly, though, there are plenty of things happening in financial markets that are unrelated to brokers downsizing.

In corporate bonds, for example, the nature of the market is changing. Far more companies now sell bonds than at the time of the crisis. There has been a 71 percent increase in the number of issuers in the U.S. high-grade market since 2009, according to JPMorgan. That gives bondholders a better shot at diversification, a significant bonus from an investing point of view.

This change comes with a liquidity penalty, however. Bigger-sized bond issues, from prominent borrowers, have long been easier to trade than smaller ones. Yet because there are more issuers, the share of companies with debt that accounts for 0.5 percent or more of the U.S. high-grade bond index has shrunk to around a third from 50 percent in the past six years.

The debt of those bigger issuers traded on average 31 percent more than other paper last year, according to JPMorgan – a trend the bank’s analysts say has persisted for a long time. They also reckon that the increase in more companies borrowing smaller amounts accounts for almost 10 percent of the decline in high-grade bond turnover since 2006.

That doesn’t even address the increasing role played in the market by non-banks. Mutual funds and exchange-traded funds own far more bonds than they used to. The two classes of funds now hold 22 percent of U.S. high-yield bonds, almost double the proportion nine years ago, according to Lipper. Of course, in a selloff that could mean a rush for the exits and further pressure on liquidity, but it also calls into question old assumptions about the central role of investment banks.

Moreover, there is plenty of money waiting on the sidelines for perceived bargains. Alternative investment managers have around $300 billion stashed away, calculates Deutsche Bank – more than Fed data shows on Wall Street primary dealers’ books heading into the crisis.

Such potential buyers, though, are only going to be interested at prices that look attractive. Schwarzman et al imply that banks have helped in the past both by ensuring sellers can find a buyer and that bonds or other assets can be sold at prices that are acceptable to sellers. But that’s not what has happened.

In the 2008 crisis, prices of problem bonds plunged as buyers vanished. Wall Street brokers, like any other traders, buy with a view to selling quickly at a markup. If trading desks don’t think there are buyers, they either fail to answer sellers’ calls or offer ultra-low prices. In last October’s mini flash crash in the U.S. Treasury market, they simply switched off the electronic trading networks that handle much of the business.

Moreover, investment banks’ past appetite for keeping more bonds on their books wasn’t solely driven by a desire to facilitate more trades for clients. For much of the 1990s and 2000s, sitting on bonds as prices rose was an easy way to make money. Slumps in 1994, 1998 and 2008 reminded bankers this wasn’t always a sure thing.

With short-term interest rates near zero in big economies the likelihood is they’ll rise, with a matching fall in bond prices. It’s possible that Wall Street will mop up fewer bonds than in the past in any ensuing selloff, but it’s also possible that new types of buyers will step in, and that reduced leverage in the system – a major goal of post-crisis regulation – will diminish panic selling.

Such shifts should be all in a day’s work for markets. As Bank of England Governor Mark Carney said in his Mansion House speech last week, “more expensive liquidity is a price well worth paying for making the core of the system more robust.” Wall Street’s biggest names may be chafing under the second part of that, but they won’t help themselves by embellishing the reality of the first.


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