The differences in the dynamics of the US Treasury, Corporate Bond, and equity markets provides great insight into why corporate bonds are susceptible to the Volcker rule.
In the same hearing last week, where the Volcker rule- which prohibits proprietary trading by banks- was discussed and covered by The Industry Spread, the ranking member- leader of the minority- New York Democrat Carolyn Maloney may have imparted wisdom when she described the differences between stock markets and corporate bond markets.
“The Stock market is a highly electronic mostly exchange traded market made up of mom and pop retail investors, institutional investors like mutual funds and pension funds, bank and brokers, and high-frequency trading firms; trades in stocks happen so fast that they’re measured in microseconds- that’s one millionth of a second-this is largely because stocks are highly standardized,” Maloney stated. “In contrast, the corporate bonds are not standardised at all; a big US company like GE (General Electric) has around 900 different bonds outstanding each with different terms, maturity dates. So, trading is much more fragmented in corporate bonds; as a result, corporate bonds don’t trade on centralised exchanges like stocks instead they trade through dealers like banks. Dealers hold large inventories of bonds so that when an investor like a mutual bond wants to buy a corporate bond the dealer can sell them that bond out of its own inventory. So, in corporate bonds, it is the dealer who is responsible for an orderly market.”
The Volcker rule has- at least if you believe critics like Jeb Hensarling- the Texas Republican who is head of the House Financial Services Committee- is causing an out of control regulator to encroach on the legitimate market making activities in corporate bonds.
Because these market makers are critical to, for lack of a better word, making the market, the rule is setting the stage for a liquidity crisis which Hensarling argues will come in times of stress.
The so-called sixty-day rule- which was also discussed in the hearing-has emerged as the major point contention. That rule- one of several Volcker rule related regulations- stated that trades made within sixty days of each other would be presumed to be proprietary.
Market makers strive to make as many trades as possible, putting them in its cross-hairs.
But Maloney also said something which suggests the rule is having little effect; Maloney said that US Companies raised $1.5 trillion in the corporate bond market in 2016 the fifth year of record highs.
If corporate bond issuance was at record highs how can there be a liquidity crisis?
Hensarling has repeatedly stated that you won’t see liquidity crisis until times of stress; an opaque and hypothetical argument which can’t be proven because you are trying to stop an event before it happens.
Proponents of the rule say that US markets are vibrant and dynamic and adjust to common sense regulations organically.
The Federal Reserve- which recently acknowledged that Volcker rule was having some effect- downplayed it making this very point: “Overall, the degree to which dealer balance sheet constraints affect corporate bond market liquidity depends not only on dealers’ capacity and willingness to provide liquidity, but also on the extent to which nonbank financial institutions such as hedge funds, mutual funds, and insurance companies fill any lost market-making capacity.” The Federal Reserve stated in its Semi-Annual Report released earlier this month.
The fate of the Volcker rule remains up in the air. While the Financial Choice Act- which passed out of the House of Representatives – would repeal it; that bill has been stalled in the Senate.