The financial crisis is now six years behind us. Massive leverage, thin capital cushions, and a global laissez-faire legislative agenda are gone. To ensure financial surety, regulators are forcing banks to take less risk. But how will this impact the markets?
The financial crisis is now six years behind us; the G20 have weighed in, and Dodd-Frank, EMIR and Basel III have become law. The world is now a very different place. Massive leverage, thin capital cushions, and a global laissez-faire legislative agenda are gone. Today’s primary directive is “never again”: no more financial crises, and no more bailouts.
To ensure financial surety, regulators are forcing banks to take less risk. But what does this mean, and how will it impact the markets?
In making banks less risky, legislators and regulators are increasing the capital cushion that protects banks; reducing banks’ overnight funding reliance; limiting proprietary trading; increasing the required margin on OTC derivatives; and pushing significant counterparty risk into central clearinghouses.
While risk in the banking sector has been reduced by limiting the types of assets banks buy and hold, it also has increased banks’ cost of capital – their cost to borrow. This exerts pressure on large, covered organizations to transition their trading businesses from profiting on appreciating assets to one more based on the collection of fees. This moves banks from trading as a principal to trading as an agent (riskless principal), and from providing liquidity to brokering liquidity.
While banking is inherently a network-based business acting as a hub to net clients’ risks, this new model requires banks to net these risks more quickly, as the penalties of warehousing assets have increased. This effectively puts banks out of the storage business and squarely into the moving business, as risk shifts from the intermediaries to the asset holders, whether they are issuers, underwriters, or investors.
While banks will hold less risk, this won’t be the end of the world as we know it. This transition will actually lead to innovation, efficiency, and a new wave of investment.
As banks move out of the asset storage business, both banks and investors will need to develop and acquire new valuation, risk, analytics, collateral management, matching, aggregation, and distribution technologies.
Increasingly, banks will need to source liquidity from a greater array of market participants, more efficiently. The only way this occurs is if these market participants have a better understanding of both price and liquidity – i.e., greater transparency. Greater transparency will be the first critical step as intermediation migrates from a principal to a riskless principal service. As transparency increases and investors and issuers begin seeing a wider view of the market, it will give investors greater confidence to transact, allowing them to turn over their portfolios more frequently and hasten the development of new trading venues and distribution mechanisms.
Unlike the equities markets, where most markets are either limit order books or dark pools (dark limit order books), OTC products such as fixed income markets will not develop as a unified, or even a bifurcated, market structure. The common idiom, “Bonds are not bought, they are sold,” is true. The supply, complexity, and unique nature of many bonds make them much more challenging to understand and, hence, trade than a stock.
Many fixed income/OTC products rarely trade after they are issued and absorbed by investors. Only a handful of the millions of outstanding issues trade weekly, and far fewer are traded daily. Until issuers/underwriters can simplify product structures, re-open older issues, create a generic trading facility that can be subsequently allocated (such as a mortgage-backed security), or create effective hedging products, the development of an efficient market for secondary OTC products will require multiple and complementary market structures, such as order books for the liquid, streaming liquidity for the somewhat liquid, RFQ for the less liquid, call markets (or sessions) for the even less liquid, and the trusted telephone for the truly somnolent products that seem frozen in investors’ inventories.
Increased pricing transparency and more open trading enable banks and vendors to develop better communications protocols, valuation methodologies, risk and collateral management tools, and more integrated order and execution management platforms. These tools will enable investors to better understand a series of risks from which intermediaries have historically insulated them. Better and more accurate data will enable investors to better value their investments, which will in turn facilitate increased turnover and more efficient markets, and should expand the market. Again, while OTC products, and specifically bonds, are not stocks, decreased intermediation in equities led to increased investment in connectivity protocols (FIX), the migration of trading from people to machines, lower commissions, and greater control of the trading process.
While this process has made the trading of equities more complicated, for the majority of professional investors, it has lowered commissions, tightened spreads, and put the buy side in increased control of its destiny.
While new financial regulation is changing the world of banking, the world is becoming a much safer place. Large banks have deleveraged, and trading risk is shifting from intermediaries to investors and corporations. This shift is starting a cycle of innovation that not only will make the economy safer, it will lower trading costs, increase liquidity, and put corporations and investors in greater control of their financial livelihoods.
While financial regulation was intended to make the world safer, it will also make markets more transparent, less intermediated, and less complex. This will benefit not only institutional investors and corporations, but individuals on Main Street as well