Regulatory changes under the Dodd-Frank Act designed to reduce the risk of another financial market downturn may have the reverse effect so suggests an article in “FierceCFO”, the online magazine.
My takeaway from the article is that new regulations forcing large banks out of proprietary bond trading and concentrating it in the hands of hedge funds will increase the risk of illiquidity in the event of another period of instability.
The article suggests that in the event of another period of economic uncertainty, hedge funds will quickly step away from the market accelerating illiquidity. Regulators have much less leverage over hedge funds to maintain some level of liquidity than they have over the banks.
“FierceCFO” article summary
Liquidity: How regulators are fueling the next crash
We’re not fans of deregulation, but the opposite does have unintended consequences. And TABB Group just released a report that suggests the changes brought about by Dodd-Frank and other regulatory moves made in response to the last financial crisis may set the stage for the next one. How so? By shifting bond trading from banks to hedge funds, which have more freedom to pull in their horns just when the market needs the opposite. In other words, liquidity could dry up at just the wrong time. The money quote comes from Colin Teichholtz, co-head of fixed income trading at Pine River Capital Management: “These new liquidity providers can just turn off the machine in bad times,” Teichholtz said. “Illiquidity can beget illiquidity and there is no obligation on these players to make market. The danger is that the dealers won’t be around to pick up the slack. The optimum business model won’t be to warehouse risk.”
In an interesting development on this topic, Liquidnet, an equity trading “dark pool” is expanding into bond trading to provide an additional trading venue for the bond market. As the article above stresses, the trading activity conducted by hedge funds through “dark pools” can dry up at any time if parties step to the sidelines.