Capital markets participants are nearly unanimous in the belief that almost every aspect of the markets is changing: international regulation, capital requirements, liquidity, and instrument structures , just to name a few. With that much change blowing things around, it can be hard to make out forms in the murk, but gradually the shape of the capital markets of the future is beginning to emerge.
In order to make sense of these emerging markets, we need to understand the interplay of the forces at work. Much has been written about them individually, but we need to look at them in concert, not separately. Only then will we be able to see what is really happening.
International regulation – This factor has received perhaps the most press coverage, with everyone bemoaning the lack of coordination and uniformity between regulators. But the most perplexing aspect of international regulation is the very disparate time frames on which the regulators are operating. It is one thing to deal with different rules for different jurisdictions, but quite another to have to deal with rules that are unwritten but sure to come, while other versions are fully in force. Coupled with the fact that some regulators seem to think that their reach extends into other venues, regulation is among the most difficult factors to deal with.
The biggest change most participants are currently dealing with is the Volcker Rule, and its European cousin. Due to come fully on stream in 2015 (in the US) and perhaps a year later in Europe, the main impact of the VR is to insert a layer of monitoring into the trading functions of banks, not just in market-making and underwriting, but also in the hedging of non-trading risks and even in liquidity management. In most cases, banks will not be able to do that monitoring manually, so they will have to rely on software for much of it. Whether their technology vendors (either internal or external) will be ready when the rules become effective is a big open question and one of the biggest risks.
Capital requirements – The second big change is in the ever-rising capital requirements for most kinds of market participants. Basel III is by now old hat, so things might be manageable if that were the lot, but it most assuredly isn’t. First, there is the total loss-absorbing capacity, or TLAC, which was recently introduced by the FSB, expected to be as much as 25% of risk-weighted assets (RWAs). While still a proposed rule, it has raised tremendous consternation throughout the market.
Then, of course, there is the supplementary leverage ratio (SLR) which is the US regulators’ implementation of Basel III. For the big 8 US banks (the G-SIBs) the enhanced SLR requirement is 5%. As with any ratio, it matters greatly what you put in the denominator, and the SLR denominator is quite inclusive, covering OTC derivatives, cleared derivatives, and repos, making the SLR denominator significantly larger than the Basel III denominator.
The latest set of developments in this arena is the discussion of increased capital requirements for derivatives clearing houses, as people start to recognise the CCPs’ role in the concentration of risk. Importantly, almost all of a CCP’s TLAC is currently made up of the default funds supplied by clearing members, so increases in CCP capital will most likely come from the clearing community. This fact highlights the new economics of the FCM business, where increased cost and capital requirements have turned a cash cow into something of a dog, if you remember your BCG four-box.
Dealer bad behavior – After a long period as the undisputed rulers of the roost, dealers in virtually every market have taken their lumps over the last five years. Whether it is for fixing prices in a wide variety of instruments, or playing bait-and-switch in equities, dealers have faced a flood of investigations, fines, bad press and censures. The recent revelations by Carmen Segarra and the Senate Investigation Subcommittee only serve to cement the public’s view of bankers as amoral and opportunistic, if not worse. And the worst may still be to come, as the latest round of FX investigations are expected to lead to the arrest and trial of individual traders. The well-known prosecutorial technique of turning lower-level violators into informants against their bosses means that no one, including the banks themselves, knows how high the cases might go. There’s definitely a chill throughout the trading room.
Costs and Spreads – Every dealer in every market has some story about the phenomenon of higher costs on top of reduced spreads. We can trace the increased costs to many of the forces covered above: new regulations requiring new monitoring, increased capital levels, and a never-ending string of legal events. But the reduced spreads come from a different set of drivers.
One cause is the increased cost of trading for customers, as clearing becomes more and more prevalent, and customers look at hedging strategies more skeptically. As the same number of dealers chase a smaller customer demand, spreads inevitably come down. Additionally, in the largest securities market in the world – US treasuries – the Fed has removed so much of the supply that trading volume has fallen sharply. As a result, dealers have reduced treasury trading staff and come to rely on algorithms to make markets, instead of people.
Another cause has been reduced volatility in most markets, also due to monetary policy. After almost six years of quantitative easing and slow growth worldwide, markets have fallen into something of an induced torpor. Everyone is primed for the moment when the Fed begins to reel in all that cash they created, and there have been several false starts by the markets, but meanwhile the level of liquidity has been far in excess of the demand.
Finally, we have to recognize that some of the dealers’ trading profits came from the darker side – manipulating prices in general and especially during index-setting times or intercepting orders and acting against them, for example. If dealers are truly chastened by the new legal and regulatory environment, we should expect them to pull back in many markets.
Regulatory uncertainty – Every market disaster brings regulatory change, but the 2008-09 bursting of the credit bubble brought something else, a global free-for-all where market regulators attempt unsuccessfully to coordinate their efforts while simultaneously upstaging each other. For dealers and customers alike, the problem isn’t dealing with a set of rules, it’s trying to figure out what the rules will be. The absurdity of having reported CDS index trades in the US for over a year while still waiting for rules on single-name CDS reporting in the same country is perhaps the best example, but the global regulatory landscape looks like the Somme after WW I.
All these factors come together to create a very different market than we are used to. Some of its features:
From principal to agency – We’ve already started to see this trend in derivatives, but it will spread to most markets. The increased bank capital requirements for holding positions, as well as the increased monitoring required under Volcker, is already leading banks to re-examine the profitability of principal trading. Some banks have already begun to shift to an agency model, and more will follow. That will lead to…
Reduced liquidity – As trading costs rise for everyone, everyone takes a sharp pencil to their trading strategies. Customers pare back their market usage, and dealers in turn pare back their market-making. Fewer customer trades and fewer market makers means it will be harder to move large blocks of almost every instrument, so spreads in most markets will widen. That will lead to…
Higher volatility – More agency trading and reduced liquidity will inevitably result in a jump in volatility. Reduced customer volume may counterbalance the drop in liquidity somewhat, but large customers will find it harder to get big trades done. This will all be exacerbated whenever the Fed starts withdrawing some of the $4 trillion of cash it pumped out, much of which went to the emerging markets. That will lead to…
Increased risk – Higher volatility and lower liquidity are the perfect formula for increased risk, which has been concentrated in a small number of institutions, particularly clearinghouses. The regulators have already begun to recognise the CCP risk concentration, and have begun to call for more CCP capital, but the volume of risk in derivative CCPs is not well understood, and it represents a narrow bottleneck through which everyone will have to pass, at perhaps the worst possible moment.
Much of the public discourse on market and regulatory reform has been about efforts to make the markets safer and more transparent. Taken individually, many of the recent changes have that as their objective, and regulators talk incessantly about how their efforts are achieving those goals. In reality, though, the combination of impacts may have had the opposite effect. Eventually the markets will find a new equilibrium, where customer demand is met by dealer readiness, but the road to that equilibrium will probably be pretty bumpy. The old adage of “hope for the best but prepare for the worst” might be the best formula for dealing with the markets of the immediate future.