SEC’s Piwowar Assesses Bond Market Structure

Terry Flanagan

The altered landscape for bond market liquidity raises a number of regulatory issues, including a proper baseline against which to measure current dealer inventories.

“Some have suggested using 2006 or 2007 data as the baseline because they provide the most recent pre-crisis data,” SEC Commissioner Michael Piwowar said in an April 21 speech. “Others have suggested that those years are not appropriate because there may have been ‘too much liquidity’ in the run-up to the crisis. Unless we know the appropriate baseline to serve as a point of comparison, we will not be able to properly understand the magnitude of the change.”

Market participants have traditionally sourced bond liquidity directly from dealers in the over-the-counter market. Bond dealers under this traditional model hold inventories of bonds that are used to make markets. “When dealer inventories are high, liquid bond markets typically follow and everyone is happy,” said Piwowar. “When dealer inventories are low, market participants get worried and my schedule fills up with meetings and calls from reporters.”

Recent actions by prudential regulators have added to the risks and costs of holding large inventories of bonds, he noted. For example, Section 619 of the Dodd-Frank Act — the Volcker Rule — prohibits proprietary trading by banks, which makes it riskier for banks to hold less-liquid assets like bonds and increases compliance costs related to justifying legitimate market-making activity for these securities.

Basel III’s higher risk-weighted asset requirements and supplementary leverage ratio also have raised costs associated with holding fixed income securities by making certain assets, such as corporate bonds, more expensive than under previous capital rules, and setting a higher threshold for capital to be held against gross assets, respectively.

In addition to regulatory pressures, which may make dealers less able to provide bond market liquidity, in the current environment dealers may be less willing to provide it. For example, some have suggested that the Federal Reserve’s current zero interest-rate policy makes dealer market-making less profitable, said Piwowar. Others have posited that, in the wake of the financial crisis, many dealers reappraised their risk tolerance and are raising the risk premia they demand in exchange for their services.

“Unless we fully understand the underlying causes of the reductions in dealer inventories, we cannot assess whether the reductions are likely to be permanent or temporary, or whether dealer market-making capacity is likely to improve, stay the same, or decline in response to changes in regulatory policies, interest rates, etc.,” he said.

Piwowar said he’s met with numerous groups working on creative solutions to bond market liquidity issues. Some are looking to alleviate the reliance on dealer inventories by creating exchange-like platforms for bonds, while others have been developing alternative trading systems to allow buy-side firms to directly interact with one another to satisfy their liquidity needs. Still others are seeking to improve liquidity in the future by standardizing the terms of bond issuances.

“It is interesting to note that while groups are proposing to address the liquidity shortfall in any number of ways, they each face one challenge that is the same: the complexity of the fixed income markets,” he said. “Although corporate bond issuances for the most part are not as complex as municipal bond issuances, their unique characteristics still present barriers that must be overcome if any new market structure initiatives are going to succeed.”

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