August 10, 2017 / 3:55 PM / 2 months ago

SEC says bond liquidity fears overdone

LONDON, Aug 10 (IFR) - US regulators have downplayed the impact of stricter regulation in financial markets, suggesting fears of a subsequent lack of liquidity in credit trading is overblown.

On Tuesday the Securities & Exchange Commission said in a report to the US Congress that “evidence for the impact of regulatory reforms on market liquidity is mixed, with different measures of market liquidity showing different trends”.

The report said the changes could not be ascribed to the introduction of new rules and regulations alone but had to be considered alongside other factors such as the “electronification of markets, changes in macroeconomic conditions, and post-crisis changes in dealer risk preferences”.

These trends pre-dated the Dodd-Frank Act, which outlawed US-regulated banks from proprietary trading among other measures, and Basel III, which requires banks to hold heightened levels of capital.

More specifically, in the US Treasury markets the SEC found “no empirical evidence consistent with the hypothesis that liquidity has deteriorated after regulatory reforms”. It noted that the Volcker rule in Dodd-Frank, which bans prop trading, did not apply to this market in any case.

The SEC said that for corporate bond markets, “trading activity and average transaction costs have generally improved or remained flat”. It said that “more corporate bond issues traded after regulatory changes than in any prior sample period”.

The report said transaction costs had decreased by 31bp for trade sizes below US$20,000 and were 0.1bp lower for larger trade sizes than the 5.8bp before the crisis. The SEC did say trading was “more concentrated in less complex bonds, and bonds with larger issue sizes”.

That would suggest that market participants feel smaller or more esoteric bonds now show less liquidity since banks can no longer hold such a wide range of inventory, as the report noted. However, it said the number of dealers involved in the market had not declined.

Other pockets of seeming illiquidity were also observed. For instance, it said dealing costs had increased for sizeable trades of larger bonds of more than US$500m issue size, some investment-grade bonds, younger bonds issued under two years ago and bonds with maturities over 20 years.

It also said that in times of severe market stress “dealers may not lean into the wind, but instead make larger cuts in inventory of bonds that are aggressively sold by their customers.” The SEC said this supported findings that “dealers decrease liquidity provision” during such episodes.

Finally it said that increased electronic trading and use of single-name credit default swaps may have added to extra liquidity provision since the crisis.

HIGH YIELD PICK UP

In March, markets regulator IOSCO reached similar conclusions in its own report into the corporate bonds markets, finding “no substantial evidence” that market liquidity between 2004 and 2015 had “deteriorated markedly from historic norms for non-crisis periods”.

In a separate report on Wednesday, Bank of America Merrill Lynch said that credit market liquidity remained “challenging” because “lower bond supply over the past year and strong central bank buying has resulted in fewer bonds being available for traditional credit investors to buy”.

But it did find that while trading frequencies had “declined in the high-grade euro and sterling corporate bond market, we have seen an improvement in the high-yield space. In the latter case, the liquidity is now concentrated in fewer issues of higher notional”.

The broker said that this could be because “a broader investor base is looking to trade HY bonds” as higher-yielding opportunities continued to be sought. “Over the past 12 months, a higher proportion of the available stock is trading,” it said.

A survey of BAML clients found that three-quarters of investment-grade investors thought liquidity had deteriorated or remained unchanged but the same proportion of high-yield investors thought it had improved or remained the same. All said spreads had tightened over the past year.

BAML agreed with the SEC report in finding that liquidity was concentrated in certain benchmark bonds with five and 10-year bonds highlighted as showing better liquidity in terms of tighter spreads and higher turnover. (Reporting by Christopher Spink)

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