The coronavirus outbreak has been a massive shock to the financial system. Periods of heightened market volatility tend to coincide with limited balance sheet capacity due to tighter risk constraints. In this blog, we discuss the liquidity provision by large banks in the past few months in the broader context of the impact of regulatory reforms on market liquidity and market-making activities of dealers in the past several years. We provide evidence that dealers in the bond market provided liquidity and smoothed market reactions to COVID-19 shocks despite the decline in risk-taking capacity.
A 2014 report by a group of central banks, the Committee on the Global Financial System (CGFS), documented signs of reduced bond market liquidity because of declining bond dealer risk-taking capacity. The report identified several regulatory reforms that were expected to raise the costs of market making. To see the links between market making in over-the-counter (OTC) markets and regulatory costs, consider a market maker’s profit and loss (P&L) account as shown in Figure 1. There are two broad categories of net revenues. First, facilitation revenues that reflect bid and ask spreads, net of the cost of trading. Second, the P&L account is complemented by inventory revenues. These revenues are comprised from interest income and valuation gains generated by the asset held in inventory net of the cost of funding and hedging costs. Dealers often fund their market-making activities in repo markets. Regulatory market, counterparty, and credit risk capital requirements are other important cost components. As described in the report, hedging, funding, and regulatory capital costs have all increased significantly in the past ten years due to regulatory reforms.
Figure 1: Market maker’s P&L account. Other costs include, e.g., trading desk and support staff, compliance, and administrative costs. Other revenues may include income from other business lines, e.g. syndication, that is attributed to the market making desk. Source: CGFS (2014).
In sum, regulatory reforms have increased dealers’ market-making costs in the past several years, which has reduced their ability to supply trading and market-making services to their customers. The demand for trading and market-making services, however, has not decreased. The COVID-19 pandemic is a case in point for the corporate bond market. As risk and uncertainty have risen, the demand to trade corporate bonds has risen too as some market participants have sought to raise cash and hedge risk while others have sought to put risk capital to work. Against this backdrop, how have bond dealers with less committed capital to absorbing supply and demand imbalances reacted? Recent evidence suggests that large banks actively made markets for their customers and smoothed out some of the market reactions to COVID-19 shocks.
Specifically, a new paper by researchers at the Federal Reserve, UCLA, and the University of Illinois estimates dealers’ inventory accumulation between February 19 and March 30 of this year. Figure 2 presents the estimate of dealer inventory from their paper. On March 17, the Federal Reserve introduced the Primary Dealer Credit Facility (PDCF) to lend money to broker-dealers and take bonds as collateral. On March 23, the Fed announced it would buy bonds directly from companies issuing new corporate bonds, and that it would also buy bonds on the secondary market through the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF). Figure 2 shows that dealers absorbed some inventory in late February, before financial markets became stressed on March 5. At that point, dealer inventory leveled off. This trend continued until the introduction of the PDCF, PMCCF, and SMCCF. After March 18, dealer inventories rose from roughly $2.5 billion to $8.0 billion indicating a significant increase in bond inventories. Importantly, this inventory accumulation supported customer sell orders and moderated some price pressures that could have exacerbated bond market volatility.
Figure 2: Cumulative inventory change in the dealer sector, USD billions. Shaded area represents 95% confidence bands. Source: Kargar et al (2020).
One of the policy implications of the 2014 CGFS report was that increased costs and reduced risk-taking capacity among dealers would require central banks to play an active role to help stabilize markets in stressed conditions. The COVID-19 pandemic largely bear out the report’s prediction. In the U.S., market reactions to recent shocks have been smoothed out to some extent with dealers’ market making along with the Federal Reserve’s liquidity provision and market interventions. Policymakers should review market functioning during the pandemic to assess the impact of regulatory reforms on large bank liquidity provision in key financial markets.