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.
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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
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
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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