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Fed Governor: Regulation a “Possible Contributor” to Reduced Fixed-Income Liquidity

Federal Reserve Governor Lael Brainard in a recent speech acknowledged “the role of regulation as a possible contributor” to the reduction of liquidity in the fixed income markets. However, she argued that “it is important to recognize that this regulation was designed to reduce the concentration of liquidity risk on the balance sheets of the large, interconnected banking organizations that proved to be a major amplifier of financial instability at the height of the crisis.”

Brainard noted that “it is difficult to disentangle the effects on liquidity of changes in technology and market structure and changes in broker-dealer risk-management practices in the wake of the crisis on the one hand and enhanced regulation on the other.” She argued that while regulatory requirements have changed the way that market participants approach risk management and affected balance sheet allocations, that algorithmic traders have also influenced Treasury markets.

She argued that recent volatility in fixed income markets “has underscored the importance of ongoing attention to the resilience of market liquidity,” particularly under stressed conditions. Brainard noted that bid-ask spreads and the price impact of trades remain relatively unchanged in the periods before and after the October 2014 volatility in the Treasury market. However, “both anecdotes from market participants and the declining size of trades in some markets suggest it may have become more expensive to conduct, and may take more time to implement, large trades.” Additionally, “there may be some deterioration in the resilience of liquidity at times of stress, along with a greater incidence of outsized intraday price movements.” Brainard noted that the liquidity characteristics of historically liquid bonds remained mostly the same, but instruments that have historically been less liquid have seen a further reduction in liquidity.

Brainard suggested that market participants “may be using relatively more liquid instruments to hedge exposures in other less liquid market segments, perhaps unintentionally contributing to increased correlation across markets.” In addition, she noted that liquidity segmentation, more electronic markets, and faster trade execution “might be contributing to increased linkages across markets.”

She said that “[m]utual funds holding relatively less liquid assets is one area of focus” when considering market liquidity resilience due to a potential first-mover advantage. Brainard noted that the Federal Reserve has been monitoring for “signs of liquidity strains associated with the recent increases in spreads for high-yield corporate bonds, as well as for idiosyncratic events affecting particular funds in this segment, such as the events surrounding the abrupt closing of Third Avenue Management's Focused Credit Fund last December.” While she called the SEC’s liquidity proposal “notable,” she said that the Federal Reserve “will continue to undertake more granular analysis of liquidity resilience and associated risks.”