« Exchanges at Goldman Sachs

Brittle Markets: The Risks from Falling Liquidity


Steve Strongin, head of the Global Investment Research (GIR) Division, and Charlie Himmelberg, GIR's co-head of Global Markets Research and global head of Credit and Mortgage Strategy Research, discuss the importance of liquidity in the market, the vulnerabilities of less-liquid markets and proposals to restore liquidity without undermining market safety.

This episode was recorded on August 11, 2015.

This podcast should not be copied, distributed, published or reproduced, in whole or in part. The information contained in this podcast does not constitute research or a recommendation from any Goldman Sachs entity to the listener. Neither Goldman Sachs nor any of its affiliates makes any representation or warranty, as to the accuracy or completeness of the statements or any information contained in this podcast and any liability therefor (including in respect of direct, indirect or consequential loss or damage) is expressly disclaimed. The views expressed in this podcast are not necessarily those of Goldman Sachs, and Goldman Sachs is not providing any financial, economic, legal, accounting or tax advice or recommendations in this podcast. In addition, the receipt of this podcast by any listener is not to be taken as constituting the giving of investment advice by Goldman Sachs to that listener, nor to constitute such person a client of any Goldman Sachs entity.

Copyright 2015 Goldman Sachs. All rights reserved.

This is an unofficial transcript meant for reference. Accuracy is not guaranteed.
This is exchanges of Goldman Sachs. Were people from our firm share their insights on developments currently being markets industries in the global economy, I'm Jake, seaward global, had of corporate communications here at the firm, concerns about bond market liquidity and become increasingly pronounced in recent months in ninety. Here debate among business leaders and policymakers. This is now Thus an esoteric issue for finance walks, either in an odd bed in the Wall Street Journal, Steve sportsmen seo private equity, firm Blackstone wrote that a liquidity. Drought can exacerbate, or even trigger the next financial crisis, to discuss the state of mark queried today. In this debate I joined by Goldman Sachs thieves, strong and head of the global investment research to this and Charlie Hemel Bird CO head of global markets. Research within global investment, research, Steve Trolley, welcome to the programmes.
Steve many people involved in financial markets have voiced concerns recently by decline in market liquidity. explain what this issue is all about, and white matters sure particular participant it simply harder to get trades done. I must become more expensive, messrs It takes longer to execute strategies. And many asset managers have been put in a position of where large number of investment strategies, no longer work, those that invite training and out of positions quickly. Those that choir leverage? All of those Things have become essentially impossible to execute and of those strategies being missing even the more normal by and hold strategies are harder to do, and it's hard to leave positions. Why this matter, too. consumers, who are transacting in the market place every they might have a four one Kay consumers they may on a small business. But all this market activity scene
largely irrelevant their daily lives wise it matter to them. It's gonna impact the consumer in three different ways at different moments. first is if we ever do, have a market failure and they CUP one morning and there Time and savings are worth ten percent less than they were the day before they're going to realize, care about market players and varied this right? You know it currently we have seen the equity market dislocate. But if we were happened. Is the bond market went up and so the retiree then saw a modest reduction and sometimes even a gain in their retirement portfolio of the weather, I guess I've been structured now we can eat. See the equity market and the bond markets have dramatically and ask an impact there is in a way we ve never seen before. To do so suddenly without warning and without a real, clear reason, and that's going to really, I think, break faith with markets. impact people in a serious way. The second
It is going to impact the way. Corporations manage risk. Weather an airline managing ticket ICES car company manage in the price of aluminum for a new truck with Commodity prices, skyrocket. If the Mark haven't, allowed those companies, the hedges, that risk well the consumer, who's gonna pay the price, not the company and so could be the truck that now costs two thousand dollars more I'm. It could be that trip to see your kids in your grandkids that all of a sudden is three hundred dollars more it's gonna, be some company having to pass on those prices because they weren't actively able to use the markets to keep their costs, predictable threat and the third. Which is maybe the biggest of a long term impact. Is This changing the ability of different types of companies to compete we ve seen tremendous fragmentation of the market that provide, competitive advantage for the largest corporations against the smallest companies
and as a result, we are seeing a reduction in consumer choice were seen less research and development expenditure in the economy, where seeing economic power concentrate in a smaller number of companies in the overall level of competition in our economy decline that not long term good for the consumer is going to be very hard to pinpoint the exact moment or good, a problem that has occurred because that, but over time, Twenty years that one may matter more than the others, Charlie use specifically looked at the corporate bond market, we're locked, Companies are borrowing. It today is very low rates. but trading volumes are down. How does the decline and liquidity show up in that space? It's a question. That's vexed alot of researchers on the topic, because I think, when you set out to go look for evidence of liquidity. It turns out to be surprisingly slippery and hard Nl down There are good reasons for some of which Steve stipulated to, but I think they go mainly to the fact that investors
firms and the dealer community all respond to the fact that the terms of trading or changing specifically in but credit market, I think a big shift. That accounts, for example, for the decline and bit bitter spreads is shifting from dinner, mediating markets on a principle basis which is that? A dealers steps in between a potential buyer and seller in the market and holds the risk while they look for the other side of the market, but that's the way the corporal on market has traditionally transacted, but as that cost of intermediate risk has gone up and the tools like CBS in a single labour market have become harder to access the asked of doing trades on principle basis has got up, and so, as a result, clients investors have tended to shift away from principal trading to its known as agency draining and where is essentially forces. The client to do is to wait and sacrifice immediacy it forces
and to transact the wrist transfer over a longer period of time, so in equilibrium that results bit aspirate your tighter alot of people look at those numbers and say Jean Louis, like I proprieties, bear exactly but in fact, what's happening, services, that clients are having to wait longer to get the same amount of risk transfer and often when we say wait longer people go what's the matter with waiting on a while back to have a sense of two things: what actually the time frames. So, when you're done about banks, for example. about a large multinational bank, a city gate, Will you can trade fifty million dollars those bonds in an afternoon. If you go down to the next category of banks below the CFA's that can take two weeks If you go down one more category that can take three months, and so when you, when you're, going from two hours to three hours to get a trade done, that's not a big deal when you're going from too to six weeks to get a trade done. That's a very big deal
And how might that play out in a crisis and allow the worries about market liquidity really stem from a concern about what will happen? A crisis in a time of stress has as the regulation, the post crisis regulation left us a little bit more vulnerable, probably more vulnerable one of them. Things that when you ve lived through a couple of crises, and now my experience goes back to the eighty seven crash. Why, of the big questions in the marketplace. Have we seen the selling is done? The phrases Times uses capitulation. And people are willing to step in to take risk until they have the sense that they ve seen the bulk of the selling. If you have market, where you can't get stuff done. You don't know if the selling finished and that could cause the markets to mouth for a prolonged period of time and particularly if it ends up being in a fixed income markets, would never really seen that before that could have very drama,
but somewhat unpredictable consequences for the way the economy work in things that may be the two thousand and eight crass so bad was, actually cause the fixed income markets, the malfunction in the short term- and this would probably cause the fixing of markets, the malfunction in the long term. we ve never seen before, and so is easy to say it's not a problem, it's easy to paint a horrible picture The reality is it'll, be a step under the unknown and clear why we structure the system to take that step lie people say we look, banks are better capitalize. There. holding sizeable mountain, very liquid assets, so they well position on the market, a just and a crisis. There very well position to survive a crisis help crisis is a very different thing to help and a cry This means they need to have spare balance sheet capacity to restraints on for market participants
The reality of the new rules set. Is the banks have enforced optimizing? capital imbalances, usage very, very carefully much more than in the past and as a result, there they have less spare capacity. Not more and so other much safer institutions actually will be of less use to the overall market. In a crisis the common misconceptions that I hear when I read popular discussions of liquidity issues, especially as they entail the carbon market. is the notion that somehow the banking sector is the other side of the market in a crisis. False metaphor, because the banking sector is there to help move risk from weekends, too strong hands, and especially in Urbana market, for example, when a bond falls from investment great, I yield that usually entails the bond shifting to a different portion, the investor base and then again if it falls from high yield in distress, that's yet again a different pool capital with different types of expertise and so forth, and I think that
cost of not having a functioning banking system and an interview d function in a crisis as if those wrist transfers can happen as quickly and so risk it's trapped in the wrong hands. I think the agri fact that, on the real economy is at hand, actually increases the amount of risk that risk takers have to own inappropriately, possibly and therefore, impedes their ability to take risk, which is essential, obviously, to growth and investment So one of the arguments you hear a lot is that there are others who were better position these days to play. That function managers, hedge funds, the shadow banking sector, were I couldn't. They were good day to step in and sort of provide liquidity in the event of a market. This location, they can provide capital and risk capacity. What they can provide is balance sheet, one of the things that misunderstood in the system is the difference between risk capacity and balance sheet capacity, so risk capacity
is that you have sufficient capital and willingness. Take on risk value, basically means you have immediately available funds to complete the trade today. And so typically asset managers, hedge funds, pension funds, have said Stan shall risk capacity, but if the right, in any reasonable fashion. They have very little pelagic faceted, historic what they would have done is how markets would be balanced is they would go to the banks with their capital, they were to use a banks balance sheet and Two together will the system to balance what happen the current system is the ban don't have the balance sheet to give them and so that, instead of taking that capital and apply it to the market, should have at once, you're going to have to do piecemeal over time as little bit the balance sheet become available to complete the trade which do what you discussed earlier there, maybe appetite for Trans risk, but the inability to mechanically do it.
In some ways its artifact of the way the rules were written. You know a bank today takes on balance sheet exposure that the rules constrain when put money on deposited the Federal Reserve. They have she'd constraints when they take trust, bonds from one of those clients. You just mentioned and lend them balance sheet in order to buy equities and a dislocated market that represents three or four types of balance sheet exposures. They have lending exposure there the equity exposure when their completing the trade they have, the clearing house exposures under the old rules. That was just a temporary mansion in balance sheet. There would then go away after three or four days under the current rules actually violate funding rules subtle Your leverage treasure rules party rules. As result, the peg simply can't do that trade for the client? Let's talk about The counter arguments black rocks rigid.
rigour, send a recent issue of a gold men product top of mine. I don't think, there's a look. We already problem in terms of buyers and sellers. I think there's a plumbing problem and he basically argues the changing the market structure to allow buyers and sellers more efficiently transact directly without the banks. The electronic platforms, as the solution. What's wrong with that argument, That's half of the argument that I was just making there's plenty of risk. a city in the system and the banks are safer There's not is the ability to create the balance sheet necessary to complete the trades matching platforms and the plumbing, as he was referring to Hell, you, when you were a trading, a bond for a bond and a stock for stock when you, when a trade, a bond for stock, so do now have three days of doubled, balanced exposure that somebody has to find anything To do it on a lending basis. Right that could be Fort
the balance sheet exposure that somebody now asked to fund. That's worth system has become brutal. It's the ability to ass things through its, not the abyss, to take risks, and you, refer to, that is plumbing problem, but it's really. Trends in the way? The? U S. Banking system works, Observers in this debate think the whole you of liquidity is being raised by the banks to roll back Dodd Frank more money, the CIA, of Oppenheimer Fun, said if bacon convey the FED and other regulators. They can get relief on Dodd, Frank, that's what they want more than anything else. What's your response to critics like I see this whole debate around the quantities and effort by the banks to roll back regulation. what are the issues and most the regulators have suggested it's time to look at the king, the impact of the rules or regulations see Twines have really improve safety, which ones have had significant economic costs relative to that safety. I think what liquidity crisis
sort of liquidity questions. I didn't call it a crisis. Could then I'll think there's a crisis currently raised is all of the balance sheet and counterparty rules that are removing flexibility from the system. I think everyone The system agrees getting rid of the types of leverage we saw. No seven makes sense. The kinds of static funding that was available allowed people. Take on levels of risk. There were inappropriate but in the effort to make we didn't have that leverage we ve also now eliminate flexibility from the system is Clear that all that that improves safety? It is clear that it creates, illness in the system that could potentially costs market failures? That's the kind of that needs to take place. It's not repealing the rules as to just scenery, calibrating them, so they the most safety and do the least harm, as opposed to safety at all cost. I think there are also a view that there's a trade off between financial stability
and liquidity. That too, I think, is a false narrative, because if you think back and recall the way the crisis played out, a liquidity and leverage were in fact, acting and fairly dramatic ways and when market shut down and force prices to overshoot to downside than that. Obviously, forces margin calls to bind more tightly and can exacerbate de leveraging response to a shock, so think it's also misguided, even as a matter of financial stability. To pretend that you can address leverage without simultaneously addressing liquidity argument also understates how much progress was and bank safety in the corals. Immediately after the crisis the FED change the Kapital rules. That said you, how do you all good equity? You couldn't use things like proof stocks in tense bonds, to make up your equity calculations. They everything on balance sheet, so that special purpose vehicles and others have couldn't behemoths reduce capital up that's rather than they were is the basic capital ratio and theirs
new set of rules coming in place which hang actually very important, call the to our rules, which means ensure long term debt now, also acts as loss absorbing capital against her operate losses. When you, the cumulative change in bank safety because of those rules we act We have no historic episode, either the great depression Oro, seven, even with a buffer thrown in in way bank safety would be an issue in the next crisis. Really tremendous strides have been may just in terms of the bank capital regulations and in the capital structure of banks, And when you take that into account, the marginal changes in these other rules is really quite small. we actually are so far out on the tales of the statistical distributions actually becomes hard to calculate whether in fact, there any significant change at all.
ass, her so much safety has been created in the core capital and core capital structure rules to a lot of people outside financial system, all the high frequency trading, all the rapid trades in and trading strategies seem of marginal utility, the real economy and there's a big debate amongst some of public policy makers about whether we should be encouraging more patient long term by an hold strategies and de emphasising this sort of short term investing equity markets, but also in fixed income market. So, what's the valley The society of deep. Liquidity in the markets. Less focused their fixed income here I think the question is a subtle one, as it entails high frequency trading, because there are different degrees of high feeding about just conventional daily liquidity. I think you know the high level point I would like to make. Is that liquidity and liquid capital markets,
really central to the efficiency with which the market operates in that may be high frequency trading that may be intermediate freak, he trading, but you need liquidity. However, it supplied for capital more to allocate capital efficiency for capital markets to respond to new information that becomes available over the course of projects? in for the operators of those products to adjust accordingly. Weather high frequency trading per SE is central to that are not actually have quite a bit of uncertainty, it myself. But what liquidity is important to me, seems unambiguous, and so I think that the question for policymakers and academics and researchers alike. To seek to understand is whether the high frequency his additive to market liquidity or possibly a negative because this possible to imagine it? So someone buys a long term corporate bond. Why should they be able to turn around and sell it? The next day, investors, lots of mistakes raid, the efficiency the economy relies on the ability to respond to those mistakes in the pull capital away from project
or failing and allocate that capital to the next new thing and the prom with an illiquid secondary market? Is that your kind of stock, if your initial repetitions that you don't have that same plus, although aliens misallocation of capital to projects that are no longer makes sense in today's economy, exactly Marconi, Germany, Bank of England is on the record as saying that more expensive, acquitted, the price well worth paying for making the core the system more robust and. He's not alone in seeing some reduction in liquidity is a necessary byproduct of a sure and save her financial system. Do you see that as a false trade off simply put yes or false, It is a real trade off to a point which is kinds of leverage Seven times leverage that you saw some hedge funds operating at pre crisis. generate liquidity. That also was part and parcel part of the instability we saw during the crisis.
and getting rid of that static leverage is actually part of making the system safer. We have also, however, in the rules that got rid of that static leverage. Gotten rid of this system is ability dynamically adjust when allotted Aids need to occur in a short amount of time. We see now, every quarter at the end of quarter people want to use their balance sheets little differently in the quarter. Its balance sheet intensive, all of a sudden interest rates go up for the last few days of the quarter, sometimes dramatically or the Swiss National Bank decides they need to change the way they deal with their currency. All of a sudden, the markets fail for a couple of hours that because of the system's lack of ability to dynamically adjust to those moments were now getting a lot of safety for having approved the dynamic ability the system to adjust, and that's where I think need to revisit the rules, getting rid of the static leverage made a great deal of sense, getting rid of the system's ability dynamically adjust. Probably not worth the trade off. There's a lot
But fragmentation the fixed income markets in general. What is the value that serve to these corporations and others that are issuing debt of her such a vast number of products in the space and added we get you a simpler answer that really can be looked upon as a nurse in Europe. The United States, if look at one of the core differences and corporate culture between the two places in the United States, a much smaller companies historically have been able to raise. Funds in the public markets have been able to issue bonds have been able to get tradable equity as well, in part of the market economy and have gained capital cost benefit and have been more competitive. Companies, because of it as them could becomes more fragmented vote. vantages, become available to a smaller group of companies, the will for five thousand. U S equity index and now has, Stan thirty. Seven hundred members. And so were actually seen. One has been one of
stork strains of the? U S economy, which is the depths of its public markets, shrink and become available to a smaller number of companies The real answer to your question of was the loss here is that true in base of corporations and that shrinking fuel for the future growth and fuels concentration in the bigger companies which have ready access to cheap money. Financing. In one of the things we ve seen a rebirth of is captive banks who cooperate. and funding there cameras and their suppliers, because they actually have cheaper funding than the banks to. We see a real change in the competitive balance, favouring the largest corporations with the easiest access to public markets whose instruments are a liquid seed, new traced. A lot of this in the course of the conversation to base the unintended consequences of well meaning regulation, What would you advise? Policymakers and regulators do too? rest these liquidity issues without breaking
fix is that they put in place after the crisis. I think to core things. Take a look at the non risk based capital rules, sl are the funding rules. Counterparty rules where you ve really cited a class of activity size self is a problem. For instance, deposits but our reserve count against SL are supplementary leverage ratio. And secured lending against treasuries counts again Sl. Are you got and you look at the truly safe, dynamic adjustments. The system can make an exempt them from the rules that was common letters broadly when those rules were written and look, in those types of fixes, I think, makes a great deal of sense. I think also looking carefully at these fragmentation questions There's a lot of rules that create hierarchies where you get better men above some line and that it's always fragmentation issues take hold.
And again there not risk, based as it is, their sort of simple de market offers that were sort of used in order to avoid making risk judgments. The problem when you avoid risk judgments you and let's make one anyway, but there too, but we good risk judgments, and so I think that the core the rules, it needs to be looked at over again and then I think the other thing that needs to be done in the general reassessment rules. Isn't it standing of just how might safety has been created by the core capital and capital for rules, so the other rules are really assessed eyes margins. On top of that, and I think that creates a better tax for assessing the cost benefit tradeoffs in each of these rules. Steve trolley, take very much. That concludes this episode of exchanges of Goldman Sachs I'm Jake Seaward thanks for listening, the spot gas was real.
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Transcript generated on 2021-10-15.