Last week, economists at the Federal Reserve Bank of New York (FRBNY) issued a blog post with the title, “Did Dealers Fail to Make Markets During the Pandemic?” In this post, we review the points made in the FRBNY blog and clarify that the answer to the question posed in the title of the blog is – No. Specifically, we point to evidence showing that large dealers, such as Financial Services Forum Members, actively made markets and provided liquidity to their clients during the pandemic. Finally, we discuss factors that are relevant for understanding the incentives that large bank dealers have to make markets and provide liquidity during a period of heightened risk in light of the new regulatory environment that has unfolded over the past decade.
Large Dealers Actively Made Markets During the Pandemic
Large bank dealers, such as Forum members, actively made markets for their clients such as asset managers, pension funds and insurance companies during the pandemic. Perhaps the best piece of evidence to demonstrate this fact is the large dealer inventory level of corporate fixed income instruments. When dealers increase their inventory level, they are purchasing securities from their clients without a ready buyer on the other side to offload the risk. This activity directly provides liquidity to dealer clients on demand. Figure 1 below reproduces a plot from a recent blog by economists at the Federal Reserve Board, showing the cumulative change in the inventory level of corporate bonds for “primary dealers,” which are the largest and most significant securities dealers in the U.S., and “non-primary dealers,” the smaller dealers that make markets in fixed income instruments.
The figure clearly shows that primary dealers added to their inventory levels from mid-March through June 2020. This can be seen by observing that the solid green line is above zero over the entire period except for a very short-lived and shallow dip into negative territory in the first week of March. Moreover, it is instructive to compare inventory levels between the primary dealers and other dealers. Specifically, other dealers exhibited a steep decline in inventory levels through the month of March that was not experienced by primary dealers. Accordingly, primary dealers built inventory and supported customer trading demands in March and over the summer of 2020. As a result, we agree with the bottom line of the FRBNY blog that “thus, it appears that major dealers generally maintained intermediation activity at the height of the pandemic.”
Dealers Increased Risk Levels During the Pandemic to Support Clients
The FRBNY blog clearly makes the case that large dealers increased their risk levels during the pandemic as they took on inventory from clients. Figure 2 below, reproduced from the FRBNY blog, shows its estimate of dealer risk during the height of the pandemic.
As pointed out by the authors, large dealer risk increased for two reasons: 1) risk rose substantially during the pandemic, and 2) dealers increased their risk exposure as they increased their inventory levels to satisfy customer trading demands. Of course, these increased risk levels were offset by the substantial amount of capital and liquidity maintained by large dealers over the pandemic. Accordingly, these data clearly show that large dealers increased their risk levels to support the trading needs of their clients during the pandemic.
Dealer Risk-Taking Capacity and the Regulatory Environment
Despite the clear evidence demonstrating that large dealers actively made markets and supported clients’ trading demands during the pandemic, some have suggested that large dealers did not provide “enough” liquidity to the market. While it is always hard to gauge “how much is enough,” it is useful to consider factors that may be limiting the ability of large dealers to provide liquidity during periods of heightened volatility. Interestingly, regulators have actively been considering this issue for some time. More specifically, the Committees on the Global Financial System, a group of central banks around the world, issued a report in 2014 that discusses the state of market making by large banks. They point to a variety of regulatory constraints such as heightened capital requirements, heightened liquidity requirements, and restrictions on trading activities as issues that may hinder dealers’ collective ability to deploy capital and liquidity into market-making activities during periods of heightened volatility. While the report was written in 2014, many of its points and conclusions are particularly prescient in light of the recent pandemic experience.
Large dealers, such as Forum members, actively made markets and provided liquidity to their clients during the pandemic. Dealers continued to provide liquidity during the pandemic even though doing so increased risk for their firms. Finally, while large dealers have actively supported their clients during the pandemic, several changes to the regulatory environment over the past decade have complicated the ability of large dealers to deploy capital and liquidity into financial markets during a period of heightened volatility. Regulators should consider the pandemic experience in reviewing these aspects of the regulatory framework.