Thank you for having me here today. I appreciate the invitation to take part in this conference, and I am glad we are starting with a discussion of the critically important topic of market structure and its potential impacts on financial stability.
It is an issue that has been getting a lot of attention recently. From market participants reporting concerns about their ability to execute large orders across various asset classes, to market events such as last year’s October 15th “flash rally” in Treasury securities, questions are being raised about the changing nature of trading and market making.
Many of these questions do not lend themselves to compact, easy answers. Indeed, both secular and cyclical factors are at play, cutting across markets and institutions. The rise of electronic trading, the evolving role of broker-dealers and other nonbank participants, and a shifting investor base are combining to alter market structure in important ways. Any evaluation of this landscape also needs to take into account the overlay of an extended low-interest rate environment and the likelihood of market volatility and investor anxiety over the timing and pace of potential changes.
Today I’d like to describe how Treasury and the Financial Stability Oversight Council, or FSOC, are approaching these complex issues. It is important to understand how these changes may impact the provision of liquidity and market functioning, particularly in a stressed market environment. It is vital that our markets reliably function when they are needed most, rather than exacerbate or prolong periods of market instability. The FSOC is therefore focused on how market structure changes could affect financial stability, which is our core mission and is complementary to the efforts of primary regulators.
I would like to start by giving a brief overview of some of the secular and cyclical factors that are affecting the way our markets are functioning. Then, I want to discuss how an array of changes since the crisis should help bolster the resilience of the overall financial system. Finally, I will outline the steps that Treasury and the FSOC are taking to address these issues.
There have been significant changes in the nature of market making over the past two decades, with many activities migrating away from traditional players such as banks and broker-dealers. One of the most important developments is the expansion of electronification and automation of trading across different asset classes. As markets increasingly operate on electronic platforms, nontraditional intermediaries, such as principal-trading firms that engage in algorithmic trading, are playing a far greater role and driving trading toward smaller trade sizes and intraday holding periods. Smaller trade sizes and tighter spreads reduce the profitability of traditional market making, helping redefine that role as balance sheet capacity by traditional intermediaries becomes less important.
Electronification has been a long-term process, starting in equities in the 1990s, then moving to futures, and now broadening into fixed income. Recently, as Treasury markets have moved to electronic platforms in the inter-dealer space, algorithmic and high frequency trading has expanded. Steps taken since the financial crisis to improve transparency, standardization, and centralized clearing have helped usher this evolution in newer parts of the market, including interest rate derivatives.
While there have been significant benefits in terms of lower costs, faster and more efficient risk transfer, improved price discovery, and broader market access, these changes have also introduced operational vulnerabilities and potential liquidity risks that need to be examined.
It is also important to recognize that alongside these developments, investor demand for trading has declined. In fact, since the financial crisis there has been a decline in turnover across many asset classes and geographies, encompassing differentiated regulatory and monetary policy regimes. Deciphering a “new normal” in the aftermath of both elevated pre-crisis demand and volatility-driven crisis volumes is a persistent challenge shared by many across the markets. Here I would like to point out that while some market participants suggest this is due solely to a decline in dealer inventories and reduced market-making activity by dealers more broadly, these declines exist even in asset classes that do not operate on an inventory-based trading model. That is why it is worth exploring some of the other significant factors that may be impacting demand for trading.
First, the growth of buy and hold investing strategies is contributing to a reduction in short-term trading demand. Beginning in the early 2000s, tracking funds in fixed income were introduced. Many of these funds are best described as “beta” funds, since they are intended to simply match an index or sector and have no active management or “alpha” trading component. Products such as ETFs provide investors with exposure to a basket of fixed-income instruments with the ease of trade execution found in equities. Post-crisis, these types of funds and strategies benefited from increased demand by retail and institutional investors alike. Within the bond mutual fund and ETF space, the share of passive fixed income funds more than doubled from 12 percent of the market in December 2007 to 25 percent in September 2015. With an increase in passive investing, trading volumes and demand for fixed income liquidity should decline, all else equal.
In addition to these changes in the buy and hold space, there have been similar shifts in alternative investment strategies, including a significant decline in highly leveraged, total return trading strategies. Other areas of fixed income have seen a similar shift away from high-turnover strategies. The credit space offers an interesting example, as credit funds that incorporated long/short strategies have seen low returns and large out-flows post-crisis. In addition, there has been a very large decline in the use of credit default swaps, a favorite instrument of active investors, where the amount outstanding has fallen to roughly 25 percent of the peak level in 2007.
A key characteristic of the crisis was high levels of leverage, both on-balance sheet and in the proliferation of off-balance sheet investment vehicles. In the wake of the crisis, enhanced accounting and regulatory standards for banks forced the recognition of these risks and required appropriate levels of capital. Increased market discipline has also played a major role in reducing the demand for highly leveraged investment vehicles.
In a related vein, risk appetite at banks has declined—driven by a variety of factors, including crisis era losses, regulation, enhanced risk management, and shareholder pressure. Broadly speaking, many banks have pivoted away from balance sheet–intensive activities, particularly in the current low volatility and low asset velocity environment.
Finally, there are factors unique to the current business cycle that are significantly impacting market functioning and the demand for trading. Central banks around the globe have taken extraordinary measures to stimulate economic growth and promote financial stability. Quantitative easing and extended visibility into the path of interest rates have resulted in a low-volatility environment across many correlated asset classes. This dynamic has understandably dampened trading demand and related hedging activity.
Conversely, against this backdrop, investor anxiety in anticipation of a change in the rate environment is to be expected. A re-pricing of investor expectations regarding the interest rate environment is a natural outgrowth of interest rate cycles. These changes can sometimes be abrupt and can usher in significant volatility, as we have seen in previous interest rate cycles. But related anxiety and volatility do not imply that the financial system is fundamentally impaired and will not be able to digest such changes. I would note that periods of sharp volatility in recent years have demonstrated resilience in market functioning and liquidity provisioning. During the “taper tantrum” episode of 2013, and the high-yield oil market–related sell-off of 2014 to 2015, fixed income markets continued to function in an orderly manner.
That being said, the exit from this unprecedented period of low rates and low market volatility may magnify the potential for market disruptions—regardless regardless of any particular market structure backdrop. This is obviously a key focus for market participants and regulators, alike. And the FSOC will continue to be an important forum for regulators across markets to share information, coordinate, and respond to developments.
On this front it is worth noting that market structure issues relating to potential vulnerabilities at investment funds during periods of dislocation are being examined as part of the FSOC’s work on asset management products and activities. This effort is focused on assessing whether the structure or mechanics of certain products or activities could create, amplify, or transmit risk more broadly in the financial system in ways that could affect U.S. financial stability. The SEC is also proceeding with a series of asset management rule-makings in this area.
At the FSOC, we are focused on these changes in market structure as they relate to financial stability. These are issues that are having profound effects on both market liquidity and market resilience.
Observable liquidity in the market is a product at any time of the demand from investors and the supply from market makers. This equilibrium is derived from a diverse set of players that are impacted by an equally diverse set of factors, including technology, competitive dynamics, risk appetite, and regulation. So while we may be seeing lower turnover and smaller dealer balance sheets for securities offered, this is likely an outgrowth of the significant changes in the areas that I have just outlined. However, we should not be too quick to pronounce this shift a permanent one, especially given the cyclical factors at play. With the potential onset of a more normalized rate environment and a corresponding increase in volatility, trading and liquidity demand is likely to rise, and banks may reallocate capital to benefit from the increased balance sheet velocity of certain trading assets.
While sudden market movements or disruptive price swings cannot be avoided, it is important to understand the capacity of the system to weather these events. Accordingly, the resilience of the underlying infrastructure and key market participants must be at the forefront of any evaluation of evolving market structures.
During the lead-up to the crisis, dealers grew and expanded into new markets, and the growth of domestic markets was augmented by the significant expansion of fixed-income trading by European banks. When the crisis hit, dealers that had taken on more risk and more leverage experienced more severe losses. Not surprisingly, these same dealers’ balance sheets were not positioned to provide liquidity when it was needed most. On the contrary, they were forced to deleverage by selling inventories at the worst possible time, further pushing down prices and creating negative-feedback loops across multiple markets.
In the wake of the crisis, regulators have strengthened capital, leverage, and liquidity standards, and supervisory efforts related to stress tests and resolution plans are ongoing. All told, banks have added more than $600 billion in capital, reduced their reliance on leverage and risky forms of funding, and increased their holdings of liquid assets. Stronger balance sheets mean a greater ability to facilitate trading during periods of stress.
In conjunction with reducing traditional intermediaries’ reliance on short-term wholesale funding, it was also critical to address key weaknesses that were exhibited in these markets during the financial crisis. For example, the SEC adopted structural reforms to money market funds in order to address the risk of investor runs. In addition, supervisors and market participants have strengthened the tri-party repo market by dramatically reducing intraday credit exposures borne by the clearing banks, along with making operational improvements. Efforts are underway to strengthen and improve GCF repo markets as well.
The Dodd-Frank Act also established a comprehensive regulatory framework for over-the-counter derivatives, with increasing standardization on transparent platforms and centralized clearing as important new enhancements.
Finally, regulators have worked to strengthen the plumbing of the market. Seeking to bolster standards at key payment, clearing, and settlement entities that play a critical role and are universally relied upon, the FSOC designated eight financial market utilities for enhanced supervision. More specifically, robust risk management frameworks for CCPs, as well as limiting the transmission of credit and liquidity issues during times of market stress, have been important areas of focus for the relevant supervisory agencies, as well as the FSOC.
Taken together, these reforms have bolstered the resilience of key players, vital funding markets, OTC derivatives markets, and the underlying payment, clearing and settlement infrastructure.
Looking ahead, I would like to emphasize that challenges associated with evolving market structures need to be examined on a holistic level, across products and trading venues. There currently exist different trading infrastructures, regulatory regimes, and data availability across highly interdependent markets, such as Treasuries and interest rate swaps. With the potential for stress from one market to spill over into others, regulators need to examine risks from increasingly automated and interconnected markets on an inter-agency basis.
Compared with traditional market players, much less is known about the resilience of many of the newer players. Electronic trading platforms and related technologies have become a crucial component of the market making infrastructure, but right now there are some technology-focused providers that sit outside the traditional regulatory framework. With these new firms and platforms relatively untested in a period of market stress, this is an area that merits further scrutiny.
Let me spend my last few minutes describing how Treasury and the FSOC will continue to address these issues. As some of you may recall, Treasury was a member of the inter-agency working group that produced the report on the Treasury market on October 15th. Work continues on the important issues raised there, many of which dovetail with the broader themes the FSOC is seeking to understand. Based on its interagency structure, the FSOC is well-suited to marshal the perspectives of regulators with insight into all corners of the financial markets, as well as those of other stakeholders, to evaluate and act on the cross-cutting financial stability issues related to market structure.
Currently, the FSOC is examining potential risks relating to market structure along three dimensions, as highlighted in our 2015 annual report:
• First, risks related to operational resilience and preparedness arising from the increase in electronification and automation across several markets.
• Second, the need to coordinate prudential and supervisory efforts across different venues, and to enhance our understanding of firms that may lie outside the regulatory perimeter.
• Third, ways to improve data collection and sharing in certain markets.
These efforts will build upon the ongoing work of key supervisors. For example, over the last five years, the SEC and CFTC have implemented a series of market structure reforms to improve
transparency, risk management, and technology systems.
Importantly, the financial crisis illustrated that insufficient or low-quality data can obfuscate a buildup in vulnerabilities. Greater data transparency and sharing can improve the ability of both regulators and market participants to understand potential risks and respond effectively. Although regulators now collect more data on financial markets and institutions, critical gaps remain in the scope, quality, and access to data. We will need the cooperation of industry and coordination among regulators to make progress in important areas like price discovery and trade reporting.
In closing, I would like to stress that given the breadth of the factors at play here and the vital perspectives of a broad array of stakeholders, efforts to address these challenges will benefit from engagement with industry and coordination through the FSOC. The structural changes to financial markets that we are now experiencing must be better understood in order to help inform our next steps. As this work moves forward, we must also recognize that there are now macro uncertainties, both global and domestic, that necessitate elevated vigilance. We should not let the last five years of relative calm engender complacency. The ability of regulators to work together directly and through the FSOC and partner with market participants will prove critical to promoting orderly market functioning and protecting financial stability.