Time to Refigure the Supplemental Leverage Ratio
On Wednesday, the CFTC held a meeting of the Technology Advisory Committee. The meeting was wide-ranging, covering topics including regulatory fintech support, blockchain and distributed ledger technology, algorithmic trading, cybersecurity, and crypto assets like Bitcoin.
During the meeting, Bryan Durkin, President of CME Group, discussed the importance of liquidity provision and how recent regulations are affecting that.
“Algorithmic trading is contributing to significant volume and growth across all asset classes, and providing greater liquidity and tighter bid-ask spreads,” Durkin told the TAC. This liquidity in turn helps “all types of market participants to achieve their risk management and investment objectives, and allows them to do so at a lower cost.”
Durkin explained that Principal Trading Firms (PTFs) are particularly important to liquidity provision. PTFs “played a key role in liquidity provision and price discovery in a highly significant and highly volatile market condition” on October 15, 2014, Durkin noted.
“During the period leading up to and including that volatile period of that day, prop traders or PTFs increased their trading activity in the 10-year Treasury note futures market, they provided the majority of the order book liquidity and a tight bid-ask spread… PTFs allowed the general marketplace population to continue transacting even during the most volatile period of that day leading to a much more orderly marketplace, he said.”The criticality of PTFs extending market liquidity during this important market event should not be lost.”
But Durkin raised concerns with the way the supplemental leverage ratio is impacting liquidity provision.
“Capital treatment for PTFs who make markets in exchange-traded derivatives ignores the actual risk and correlations between positions of people offering liquidity on both sides of the market,” he added. “More specifically, it lacks recognition of delta adjustments for options and recognition of netting sets for options positions. This ultimately results in a reduction of liquidity during stress conditions. This happens by applying inappropriate costs to market exposures and this is a direct result of the supplemental leverage ratio.”
Durkin said that CME market intelligence is already demonstrating the impact of the SLR in equity derivatives markets.
“Spreads on the S&P options on Feb. 5 – 6 widened significantly more than during similarly stressed markets in the past,” he explained. “We understand the widening of bid-ask spreads to be driven primarily by capital costs, again, associated with the leverage ratio.”
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