[Senate Hearing 114-319]
[From the U.S. Government Publishing Office]
S. Hrg. 114-319
EXAMINING CURRENT TRENDS AND CHANGES IN THE FIXED-INCOME MARKETS
=======================================================================
JOINT HEARING
before the
SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT
and the
SUBCOMMITTEE ON ECONOMIC POLICY
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED FOURTEENTH CONGRESS
SECOND SESSION
ON
EXAMINING THE RECENT EFFORTS BY SEVERAL REGULATORS, INCLUDING THE
DEPARTMENT OF TREASURY AND THE FEDERAL RESERVE, TO UNDERSTAND THE
OCTOBER 15, 2014, TREASURY ``FLASH RALLY,'' CHANGES IN THE TREASURY
MARKET STRUCTURE, AND LIQUIDITY CONCERNS IN THE FIXED-INCOME MARKETS
__________
APRIL 14, 2016
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
MIKE CRAPO, Idaho SHERROD BROWN, Ohio
BOB CORKER, Tennessee JACK REED, Rhode Island
DAVID VITTER, Louisiana CHARLES E. SCHUMER, New York
PATRICK J. TOOMEY, Pennsylvania ROBERT MENENDEZ, New Jersey
MARK KIRK, Illinois JON TESTER, Montana
DEAN HELLER, Nevada MARK R. WARNER, Virginia
TIM SCOTT, South Carolina JEFF MERKLEY, Oregon
BEN SASSE, Nebraska ELIZABETH WARREN, Massachusetts
TOM COTTON, Arkansas HEIDI HEITKAMP, North Dakota
MIKE ROUNDS, South Dakota JOE DONNELLY, Indiana
JERRY MORAN, Kansas
William D. Duhnke III, Staff Director and Counsel
Mark Powden, Democratic Staff Director
Dawn Ratliff, Chief Clerk
Troy Cornell, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
MIKE CRAPO, Idaho, Chairman
MARK R. WARNER, Virginia, Ranking Democratic Member
BOB CORKER, Tennessee JACK REED, Rhode Island
DAVID VITTER, Louisiana CHARLES E. SCHUMER, New York
PATRICK J. TOOMEY, Pennsylvania ROBERT MENENDEZ, New Jersey
MARK KIRK, Illinois JON TESTER, Montana
TIM SCOTT, South Carolina ELIZABETH WARREN, Massachusetts
BEN SASSE, Nebraska JOE DONNELLY, Indiana
JERRY MORAN, Kansas
Gregg Richard, Subcommittee Staff Director
Milan Dalal, Democratic Subcommittee Staff Director
______
Subcommittee on Economic Policy
DEAN HELLER, Nevada, Chairman
ELIZABETH WARREN, Massachusetts, Ranking Democratic Member
PATRICK J. TOOMEY, Pennsylvania JON TESTER, Montana
TOM COTTON, Arizona JEFF MERKLEY, Oregon
MIKE ROUNDS, South Dakota HEIDI HEITKAMP, North Dakota
BEN SASSE, Nebraska
JERRY MORAN, Kansas
Scott Riplinger, Subcommittee Staff Director
Bharat Ramamurti, Democratic Subcommittee Staff Director
(ii)
C O N T E N T S
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THURSDAY, APRIL 14, 2016
Page
Opening statement of Chairman Crapo.............................. 1
Opening statements, comments, or prepared statements of:
Senator Warner............................................... 2
Senator Warren............................................... 3
Senator Heller............................................... 4
WITNESSES
Jerome H. Powell, Member, Board of Governors of the Federal
Reserve System................................................. 5
Prepared statement........................................... 32
Responses to written questions of:
Chairman Crapo........................................... 45
Senator Sasse............................................ 46
Antonio Weiss, Counselor to the Secretary, Department of the
Treasury....................................................... 6
Prepared statement........................................... 34
Responses to written questions of:
Senator Toomey........................................... 50
Senator Sasse............................................ 52
(iii)
EXAMINING CURRENT TRENDS AND CHANGES IN THE FIXED-INCOME MARKETS
----------
THURSDAY, APRIL 14, 2016
U.S. Senate,
Subcommittee on Securities, Insurance, and
Investment, Joint with the Subcommittee on Economic
Policy,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittees met at 10:02 a.m., in room 538, Dirksen
Senate Office Building, Hon. Mike Crapo, Chairman of the
Subcommittee on Securities, Insurance, and Investment,
presiding.
OPENING STATEMENT OF CHAIRMAN MIKE CRAPO
Senator Crapo. This hearing will come to order.
I want to thank Senators Heller and Warner and Warren and
their staffs for working with me on this joint Subcommittee
hearing on ``Examining Current Trends and Changes in the Fixed-
Income Markets.''
The U.S. Treasury market--oh, I also want to say, we have
asked each of the Chairmen and Ranking Members to keep their
introductory remarks to about 3 minutes so we can get to the
witnesses, and we have all discussed that previously.
The U.S. Treasury market is one of the largest and most
liquid financial markets in the world and is critical to the
U.S. and global economy. On October 15, 2014, the yields of the
10-year Treasury experienced a 37-basis point trading range,
one of the biggest swings of all time. The unusually high level
of volatility has generated a robust debate about why this
occurred and what it could mean during future bouts of market
volatility. I have heard that several factors, including new
regulations, have reduced certain participants' market-making
capacity, and that during stressed market conditions, liquidity
may disappear at times when it is most needed.
Following the October 15 event, several regulators,
including Treasury, the Board of Governors of the Federal
Reserve, the SEC, and the CFTC, have been working to better
understand the causes of the event and, as well, how the
Treasuries market has evolved to its present state by holding
conferences, producing a report, and issuing a request for
information. It will be helpful to understand what are the key
take-aways from these efforts and how this information and
feedback will be used going forward.
While many market participants and regulators may have
different opinions or definitions of liquidity, there is
agreement that this topic merits attention.
A recent report by the Bank for International Settlements
Committee on the Global Financial System discussed how the
fixed-income markets are in a state of transition. It
identified technology and competition, bank deleveraging and
regulation, and monetary policy as factors that have a bearing
on market liquidity. The report shows that it is not just the
U.S. Treasury's market that is affected, but the global fixed-
income markets.
These are complicated issues and I look forward to hearing
and following the witnesses' information on these topics. How
are the factors set forth in the BIS report impacting
liquidity, especially during stress markets conditions? What is
the likelihood of future October 15 events? What options are
being explored to mitigate liquidity from disappearing at times
when it is needed most? And many other questions.
I want to thank again our witnesses for being here and I
will turn to Senator Warner.
STATEMENT OF SENATOR MARK R. WARNER
Senator Warner. Well, thank you, Mr. Chairman.
You know, you and I have spent a lot of time over the past
couple years investigating particularly the equity market
structure and asking the folks at the SEC to implement pilots
to improve the way our stock markets trade. And while there are
very legitimate concerns about the intricacies of the stock
market that lead to questions about fair and orderly operation
in that space, that equity space differs greatly from the
complexity of the fixed-income markets, which, as we all know,
lack a central exchange or a system for trading, have
significant capacity with only post-trade reporting for
corporate and municipal bonds, not Treasuries, and generally
have margin of spreads that would make actually even most
equity investors blush.
As you pointed out, a lot of focus on the events of October
2014. I think we have before us two extraordinarily
distinguished public servants, and my questioning, and I hope
they will even get to some of this in their opening, will focus
on a couple of areas: Post-trade transparency, the role of
prudential regulations, the actual fixed-income market
structure, especially the role of hourly trading and we all
know there are questions about liquidity--I sometimes do
question some of our high-frequency folks who always at the
altar of liquidity seeming to trump everything else, and the
interaction between futures and other markets.
I had a longer statement that I will submit for the record,
but to try to make sure I actually stick to my 2 \1/2\
minutes, I will pass it back to you, Mr. Chairman.
Senator Crapo. Well, thank you, Senator Warner.
Senator Heller is actually presiding on the floor and may
or may not make it before we start with the witnesses, so we
will let him have his shot maybe after the witnesses.
And, so, Senator Warren.
STATEMENT OF SENATOR ELIZABETH WARREN
Senator Warren. Thank you very much. I appreciate it, Mr.
Chairman.
Thank you to the witnesses for being here today.
I just have a couple of other comments to add to the
opening statements. The title of today's hearing is ``Examining
Current Trends and Changes in the Fixed-Income Markets.'' I
want to start with congratulations to the members of the
audience who made it through that title without falling asleep.
While it sounds dry, it is a powerfully important topic that
goes to the heart of how our financial markets operate.
Liquid bond markets give participants confidence that they
will be able to sell their holdings when they want to. That, in
turn, gives them confidence to buy those bonds in the first
place. This means that ensuring sufficient market liquidity is,
in many ways, key to having a robust demand for Treasuries, for
corporate debt, and for municipal debt.
That said, there seems to be no single measure of liquidity
that everyone agrees on. In preparing for this hearing, I have
seen some analysis that liquidity in the fixed-income markets
is significantly less than before the 2008 crisis. I have seen
other analysis that liquidity is not that different. I have
seen some analysis that liquidity is less, but it does not
really have much actual impact on the functioning of the
market. And with such divergence in even the basic measure of
liquidity or what it means for the markets, someone might
conclude that any claim that liquidity is shrinking or growing
is offset by someone else who can claim the opposite.
The other issue that often comes up, and mostly from the
financial services industry, is the impact of our post-crisis
rules on liquidity, and perhaps this--because it is such a
slippery concept, liquidity seems like a convenient bogeyman
that for companies that just want to see rollbacks to Dodd-
Frank and other post-crisis financial reforms. Any claim that
liquidity was much higher before the 2008 crash must address
the question of whether there was too much liquidity, that is,
too much leverage, too much short-term lending, leading up to
the crash, and once the crash hit and the liquidity disappeared
at exactly the moment when it was actually needed, right when
the market started to panic, which suggests that the so-called
liquidity in the pre-crash years was little more than an
illusion.
If the post-crisis rules have reduced liquidity by some
measures, although not by others, it may be that the current
forms of liquidity are both more stable and more likely to
stick around when they are really needed, and so I hope that is
an issue that our witnesses will be able to address.
Thank you, Mr. Chairman.
Senator Crapo. Thank you very much, Senator Warner.
And now, we will turn to our witnesses. We appreciate both
of you for being here today and sharing your expertise on these
issues, which have been--I think we have opened up some of the
critical issues that we really need to understand better.
Our witnesses today are Jay Powell, Governor of the Federal
Reserve Board of our Federal Reserve System, and Antonio Weiss,
Counselor to the Secretary at the Department of Treasury.
Gentlemen, as I think you know, we allocate you 5 minutes
for your opening statements. We will put your full statements
on the full record, and I think you will get some very
interesting and robust questioning from the panel today.
You know what, Senator Heller just arrived, so before I
start with the first witness, if you are ready, Senator Heller,
we will turn to you for your opening statement.
STATEMENT OF SENATOR DEAN HELLER
Senator Heller. Sure. Thank you. Thank you, Mr. Chairman,
and to all the Chairs and Co-Chairs and everybody else on this
particular Committee, it is great to be here and I am glad that
we are taking some time for this particular hearing.
I want to thank our witnesses for being here today, also,
Governor and also Mr. Weiss.
The fixed-income markets are critical in the U.S. capital
markets and our national economy. I do not think anybody in
here disagrees with that. It may not be as sexy or as exciting
as the equity markets, but in Nevada, entities like the Truckee
Meadows Water Authority, the Nevada System of Fire Education,
Clark County School District, cities of Las Vegas and Reno, all
rely on issuing bonds in the fixed-income markets.
The fixed-income markets in the United States are very
large. Market liquidity is critical in having effective and
functioning markets. So, there is no doubt that the fixed-
income markets are transforming. There are early warning signs
that fixed-income markets are becoming more fragile, less
liquid than they used to be. My fear
is that sometime in the future, there may be a major period of
stress in the markets that cause significant deterioration in
liquidity, and if unchecked, these liquidity problems will
spill over into our economy.
Recently, on August 12, 2015, the Global Financial Market
Association and the Institute of International Finance released
a commission study by PwC on the state of global markets
liquidity, and in their conclusion, they said it would be
helpful for all stakeholders to better understand liquidity
conditions and the link between regulations and market
liquidity so that future regulations strike the right balance
between promoting stability and maintaining financial market
liquidity.
So, the fact that this Congress, financial regulators, and
the private sector are evaluating the current state of
liquidity in the fixed-income markets shows a growing concern
that the bond markets are not functioning as efficiently and as
effectively as in the past, and I believe that the financial
regulators need to devote more attention to the state of our
fixed-income markets.
I also think that we can improve the fixed-income markets
while also ensuring proper safety and soundness, and it is my
hope moving forward that our collective agenda should be to
preserve and restore liquidity in the markets.
So, I look forward to hearing from our witnesses. Mr.
Chairman, thank you.
Senator Crapo. Thank you very much, Senator Heller.
We have already introduced the witnesses, so we will begin,
and Governor Powell, we will start with you.
STATEMENT OF JEROME H. POWELL, MEMBER, BOARD OF GOVERNORS OF
THE FEDERAL RESERVE SYSTEM
Mr. Powell. Thank you, Chairmen Crapo and Heller and
Ranking Members Warner and Warren. I know there are
Subcommittee Members. I want to thank you for inviting me here
to testify on fixed-income markets.
These markets perform important functions in our economy
and it is imperative that we understand the significant changes
that they are currently undergoing. As I will discuss, a number
of factors have been driving these changes.
Some market participants have expressed concerns about low
liquidity across fixed-income markets, although many recent
studies have found it difficult to identify such a broad
reduction. It may be that liquidity has deteriorated only in
certain market segments. It may also be that even if liquidity
is adequate in normal conditions, it has become more fragile or
more prone to disappearing under stress.
I will offer just a couple of thoughts about the highly
unusual price movements of October 15, 2014, in the Treasury
market. As you know, the staff of the Treasury, Federal Reserve
Board, SEC, CFTC, and Federal Reserve Bank of New York compiled
a joint staff report that analyzed the factors that could have
caused the rapid rise and subsequent reversal of Treasury
prices in such a short span of time. This analysis did not
point to a single factor accounting for the sharp swing in
prices.
But, as in equity markets, advances in computing and
communications technologies have allowed proprietary trading
firms, sometimes called algorithmic firms or high-frequency
trading firms, to capture a majority of the interdealer market
in Treasuries, and as a consequence of these changes, trading
in Treasury markets now moves at extreme speed. And it may be
that these changes have also lead to greater liquidity risk or
the risk of sudden declines in liquidity.
For example, researchers at the Federal Reserve Bank of New
York have found that there are spikes in volatility and sudden
declines in liquidity becoming more frequent in both Treasury
and in equity markets. There is also evidence that liquidity
shifts more rapidly and, hence, is less predictable in these
markets. By contrast, researchers have not found these
behaviors in corporate bond markets where traditional dealers
still intermediate most trade and there is much less high-
frequency trading.
Apart from such episodes of sudden volatility, questions
about whether liquidity in fixed-income markets has broadly
deteriorated are very difficult to answer definitively, and in
exploring these topics, it is essential to distinguish between
the Treasury markets and the corporate bond markets, which have
different characteristics.
In Treasury markets, traditional measures of liquidity like
bid-ask spreads have been fairly stable in recent years, but
the changing market structure has also meant smaller average
trade size and participants now must break up their larger
trades and employ complicated strategies to avoid moving
prices. Accurately
measuring the effect of trading on prices, which is perhaps the
most fundamental measure of liquidity, can be quite difficult
in such an environment.
There are also differences between the on-the-run Treasury
market and the off-the-run Treasury market, where less liquid
off-the-run securities are traded. However, the spread between
those two markets has not appreciably changed since the crisis.
Turning to corporate bond markets, estimated bid-ask
spreads have actually declined, which could create the argument
that liquidity has actually improved. However, given the nature
of the corporate bond market, those measurements are based only
on actual transactions as opposed to quotes to buy and sell
bonds.
What we can directly observe is that trade sizes and
turnover have declined in the most actively traded corporate
bonds as they have in Treasury markets, and although observable
measures of overall liquidity in corporate bond markets appear
good, there is some evidence that liquidity in lower-rated
bonds has deteriorated. Trading in these less liquid segments
may rely heavily on intermediation by dealers, and dealers have
scaled back their capital commitments and inventories in
corporate bonds since the financial crisis.
As I have mentioned, a number of factors are driving these
changes in fixed-income markets. The financial crisis gave the
dealers a heightened awareness of the risks of large portfolios
and of liquidity provision and they substantially reduced their
portfolios and their market-making footprints soon after the
crisis and, frankly, well before the new regulations took
effect.
On the other hand, in the interdealer cash Treasury market,
the main theme is really the increased importance of trading
that is enabled by high-speed telecommunications and computer
power.
Finally, regulation has, by design, increased the costs of
balance sheet usage and in doing so has encouraged a smaller
footprint among these firms and their market-making activities.
I would say, though, that no one seems to doubt that the same
regulation has also made the core of the financial system much
safer and sounder and much more resilient.
My view is that these regulations are new and we should be
willing to adjust them as we learn. That said, we should also
recognize that some reduction in market liquidity is a cost
worth paying in helping to make the overall financial system
significantly safer.
And, I will close by noting that the supervisors do have
inadequate regular data access in the cash markets. This is
something that is a principal focus of the Treasury's request
for information and it is a very important thing.
I will stop there, and I look forward to our conversation.
Senator Crapo. Thank you.
Mr. Weiss.
STATEMENT OF ANTONIO WEISS, COUNSELOR TO THE SECRETARY,
DEPARTMENT OF THE TREASURY
Mr. Weiss. Chairmen Crapo and Heller, Ranking Members
Warren and Warner, and Members of the Subcommittees, thank you
for inviting Treasury to testify today. We have been partners
with the Federal Reserve and Governor Powell, in particular, on
several topics related to today's hearing.
Fixed-income markets, as you have all noted, play a central
role in the U.S. economy, channeling savings into investment
and providing credit to households, governments, and
businesses.
Now, the primary markets for fixed income are functioning
exceptionally well. Indeed, the past 4 years have seen record
issuance of corporate bonds, as both domestic and foreign
companies continue to rely on U.S. markets to raise capital.
Trading in secondary markets is, for the most part, also
functioning well. There is little compelling evidence of a
broad-based deterioration in liquidity. But, there have been
episodes of volatility in Treasuries, as Governor Powell noted,
most notably on October 15, 2014, as well as anecdotes that
large transactions in corporate bonds are challenging to
complete.
Now, prior to the crisis, liquidity was abundant by almost
any measure. However, this liquidity was a result of soaring
financial sector leverage and an over-reliance on short-term
funding. And when the crisis hit, that liquidity not only
disappeared, but led to forced selling that greatly exacerbated
financial distress.
Reforms adopted in response to the crisis have demonstrably
strengthened the core of the financial system and reduced
markets' vulnerability to these fire sale dynamics. Since 2009,
the largest banks have more than doubled their capital levels
and holdings of high-quality liquid assets, while cutting
short-term funding in half and increasing their deposit base.
At the same time, fixed-income markets, as you have all
noted, are undergoing a period of structural change, and this
is driven by technology, changing risk appetites and business
models, changes in the investor base, and much needed financial
reform.
The Treasury market today remains the deepest and most
liquid securities market in the world. We should have
confidence in that reality. Nearly half-a-trillion dollars of
Treasury securities change hands every day, and Treasuries
remain the global benchmark risk-free asset. And traditional
measures of liquidity in Treasury markets are healthy.
But, the extraordinary volatility in Treasuries on the
morning of October 15, 2014, with no clear catalyst, raised the
possibility that improved day-to-day liquidity may have come at
the cost of rarer but severe bouts of volatility.
The joint staff report that Governor Powell mentioned
highlighted important changes underway in Treasury markets,
including the increased presence of algorithmic trading in the
interdealer market, and we are currently seeking public comment
on the evolution of Treasury market structure and the
implications for market functioning, liquidity provision, and
risk management practices. The comment deadline is April 22,
and we would be happy to report back to the Subcommittees with
key findings.
Now, the most immediate conclusion from our work to date is
that the official sector needs more access to data and more
effective data sharing mechanisms. We expect to have a
comprehensive plan in place by the end of this year for
regulatory reporting of cash Treasury transactions.
Now, in corporate bonds, measures of transaction costs are
also within historical ranges and trading volumes have
increased, showing no broad withdrawal from the market. Average
trade sizes have begun to decline, though, as well as the
proportion of large block trades. As Governor Brainard recently
noted, these data points are consistent with anecdotes from
market participants of the need to break up large trades into
smaller ones over time. Now, in itself, this is neither good
nor bad, but it does require adjustment by both investors and
intermediaries.
Concerns have also been raised about the potential
liquidity mismatch present in open-ended investment funds that
offer daily liquidity to investors but invest in less liquid
assets. The SEC has proposed new roles to improve liquidity
risk management, and FSOC has engaged in a thorough analysis of
these risks as part of its ongoing review of asset management
activities.
In summary, fixed-income markets are healthy, providing
support to the economic recovery, but they are in a period of
transition. Policy makers are focused on enhancing financial
stability and maintaining well functioning markets through
periods of stress. And financial reform has built a buffer for
volatile times. We now need to build on that progress and adapt
to the dynamics of the new marketplace.
Thank you, and I look forward to answering your questions.
Senator Crapo. Thank you very much. I appreciate the
testimony both of you have provided.
I will begin the questioning. I will begin it with a
statement. I appreciate the attention that you are both, and
that our regulators are, giving to this issue. I think one of
the messages I heard both of you give is that we need more data
and we need to analyze this better and understand all of the
factors that we are dealing with in terms of liquidity in these
fixed-income markets, and I appreciate that. I do believe that
we have got to get the answers to these questions, because as
has been indicated by both the introductory statements by the
Senators as well as your testimony, there are some serious
questions there about just exactly how are the markets
functioning and what are the causes of the issues that are
being raised.
In that context, I would like to essentially read a few
highlights to you from the European Parliamentary Financial
Services Forum that recently analyzed these issues and just ask
your comment on these highlights. So, what I am going to read
to you is from the European Parliamentary Financial Services
Forum that recently analyzed this issue.
Quote:
Since the crisis, there have been a significant number of
regulatory initiatives that have impacted banks and nonbanks
and their clients. On a stand-alone basis, many of these
reforms have been successful in that banks and investment firms
are now holding far greater amounts and higher quality of
capital with ample liquidity, intended consequences of
financial reform. However, the linkages between all the
regulatory reforms and the market liquidity are not always well
understood, which can create unintended consequences. In
particular, banks have been deleveraging, refocusing
activities, exiting from markets and capital and funding
intensive areas, such as market making in fixed income, repo,
credit, and derivatives. These responses appear to be reducing
the resilient liquidity of some financial
markets and with it passing trade execution risk from banks to
end investors or issuers.
Let us start with you, Governor Powell. Could you react to
that analysis.
Mr. Powell. Senator Crapo, that is generally in line with a
great deal of what the research has shown, which is that firms
have reduced the size of their portfolios. They have reduced
their market-making activities in many markets, in fixed-
income, and it does raise questions that we need to address
about what the liquidity is in the underlying markets.
I think you actually have to look at markets one by one,
though. Prudential regulation is really not the headline in the
Treasury markets. If you were going to find problems that were
driven by prudential regulation, you would find them in a
corporate bond market, where much smaller portfolios, much more
demand, tremendous amounts of primary issuance, and you would
find them there. But, at the same time, read the report by
FINRA, which looks carefully at many, many different elements
of liquidity, and it just does not find a consistent story of a
broad reduction in liquidity.
So, nonetheless, we hear from market participants and also
from the group that you read about, and, you know, I do not
want to dismiss those concerns. I think we have to keep paying
attention. But, it just is not a case that is proven on the
data that we have.
Senator Crapo. So, before I go to you, Mr. Weiss, are you
saying that the evidence is not there that banks are moving to
other markets?
Mr. Powell. It is very clear that banks have reduced their
portfolios of fixed-income securities. No one disagrees with
that. But, if you look at measures of liquidity, such as bid-
ask spreads, such as the impact of trades on price, you just do
not see a consistent story. You see those measures, price
impact and things like that, as well within historical ranges.
They move up and down----
Senator Crapo. Well, you indicated that they were actually
closing, the bid-ask price ratios were closing, is that
correct?
Mr. Powell. In corporate bonds, interestingly enough, the
bid-ask spread has actually declined.
Senator Crapo. But, how deep is that? Do we know how deep
that liquidity is?
Mr. Powell. So, market depth is well within historical
ranges, but has decreased just a little bit here. Same thing in
the Treasury market. I think the issue, really, with the
corporate bond market is more that you only see bonds that
actually trade. If liquidity is preventing certain bonds from
trading, you do not see that.
At the same time, everyone is looking at the same data,
which is the TRACE data, and I would steer you again, and your
staffs, to the FINRA report, which looks at this in great
detail. And, we are looking for this story, but it is just not
in the data that we have so far.
Senator Crapo. Thank you.
Mr. Weiss.
Mr. Weiss. Senator, I am looking at the clock, and you
asked a pretty complicated question. I will perhaps answer just
one aspect of it and build on Governor Powell's remarks, which
were about dealer inventories.
Now, it is the case that dealer inventories were far higher
in the period prior to the crisis than today, but the vast
majority of those inventories were RMBS and structured credit
that are no longer being issued today for good reason. And if
you look at corporate bond inventories per se, there was a
report from Goldman Sachs which actually suggested that
corporate bond inventories in 2005 were about $40 billion and
today have contracted to around $19 billion. But, there were $5
trillion of corporate bonds outstanding in 2005 and there are
$8.5 trillion today, so the inventory was not really the core
of the liquidity market in 2005 and it really, in our judgment,
is not a good measure for inventories today.
Senator Crapo. All right, thank you. We can get into this
further, but I do need to go on to the next Senator.
Senator Warner.
Senator Warner. Well, thank you, Mr. Chairman.
I would just echo what the witnesses have said. I think if
we are going to make comparisons, comparing back to that 2005-
2008 time period is not the appropriate comparison marker, as
Mr. Weiss just said. Liquidity was higher, but it was filled
with instruments that led to the crisis. And if we are going to
look particularly in the corporate bond market, we ought to be
comparing back to earlier historic numbers, and I think that is
what Governor Powell pointed out.
Going to a slightly different place, one of the things you
and I have both worked on is a greater transparency in both the
corporate and the muni bond markets, particularly in questions
around disclosure of mark-up and mark-downs, and we are hopeful
that FINRA will come out with rules that will not be toothless,
quite honestly.
I have also been interested, as we think about some of this
transformation taking place in Treasuries, as we see more move
toward algorithmic trading, which has positives and negatives I
would be happy to hear a comment from both witnesses on some of
the concerns about that movement.
One of the things I have been interested in is transparency
around post-trade trading in Treasuries, and obviously, folks
make the argument that that would give away a bank's position
and there would be front running, although that was the same
arguments that were made against TRACE and EMMA before they
were put in place. So, I guess, in your opinion, if we were
trying to improve post-trade transparency in the Treasury
market, can we do that without impairing liquidity, and is the
Treasury Department doing anything on a structural basis to
improve that transparency?
So, if you want to both address the question around the
comparison back as well as the move toward algorithmic trading,
any value judgment around that, and then in particular around
post-trading of Treasuries.
Mr. Weiss. So, in the RFI which we have issued comments in
April 22, a whole section, Senator Warner, is on post-trade
transparency, around the level of transparency that should be
attached to official sector data. And, this is a controversial
topic. I do not think we are here to make any announcements
about that today.
What we do expect is that by the end of the year, we will
have a process in place to ensure that the official sector has
access to all cash Treasuries data and that we will have
articulated a point of view about post-trade reporting.
Your analysis of TRACE is exactly right. The market
participants anticipated a huge amount of upheaval. I think the
data would suggest, as Governor Powell reviewed, that a lot of
that has not come to be.
As regards algorithmic trading, the second part of your
question, you know, we think a couple of things. Number one,
you had hearings about equity market structure just recently
and algorithmic trading really started in equity markets, moved
into FX, and then into futures, and is now present for the past
10 years or so in cash Treasuries. And, really, all
standardized securities are now traded predominately
algorithmically, certainly on the interdealer market for
Treasuries.
And, we asked a couple of questions in this regard in the
report and in the RFI. Number one, there are questions of
operational resiliency. Some of the entities that trade cash
Treasuries, for example, are not regulated for those
activities. There are questions as to the robustness of the
pre-test environment for algorithms and introduction of
algorithms into markets. CFTC has a proposed rule, Reg AT,
which addresses some of those questions. And, you know, there
are also valid issues of practices, such as spoofing and
layering and order stuffing, which in our judgment do need to
be addressed and monitored.
Senator Warner. Governor Powell, a comment, because I do
want to get in one more question, as well, but----
Mr. Powell. Yes, just quickly. I would agree with
everything Mr. Weiss said.
On algorithmic trading and all that, it is driven by
technological advance. It is not going away. It is with us, and
it has benefits and it also has risks. The risks may be, and it
is not firmly established, but may be that liquidity can be
more flighty under stress. I would also say it is not just the
principal firms that are using this. All market participants
are electronic traders now, and it affects the structure of the
markets and the functioning of the markets and we have to get
used to it and adapt to it, and it is something we are looking
at very carefully.
Senator Warner. And I agree, we are not going to roll back
technology, but I do think sometimes, and nobody wants to sound
like a Luddite, but the idea of speed for the sake of speed at
least has to be evaluated.
I am going to just take one more question, then, Dean, if I
can, and then I will head off, and this is directed to you,
Governor Powell. One of the things that the Fed has recently
acted on, the Fed's proposal to confer Level 2B status on
certain municipal bonds, the purpose of LCR. I really worry
about this. It seems like a very conservative move. The FDIC
and the OCC have not even ruled in on this, and it is just kind
of hard for me to understand why we would say we will take a
triple-A bond rated Virginia debt instrument, or New York Port
Authority debt instrument, and somehow make that a lower status
in terms of LCR than, say, sub-sovereign bonds issued by
European nations. Why should Bavaria get a higher ranking in
terms of the level of quality of capital than a triple-A rated
United States muni?
Mr. Powell. Senator, the LCR, of course, requires these
largest financial institutions to hold amounts of highly,
highly liquid
instruments that can be turned into cash to a near certainty to
cover 30 days of potential outflow. So, it is really all about
liquidity. It is not about the creditworthiness of the
underlying issuers or anything like that. So--and what we have
done is we want them to be mostly in Treasuries, and then there
is a middle box for the GSEs, and then there is corporate bonds
and munis. It simply is just that it reflects the liquidity,
the amount of trading that occurs in these instruments, so we
wanted to include them.
By the way, banks can own as much of them as they want.
This is not a limit on what banks can own--or as much as the
law allows. This is a limit as to what counts for highly
liquid. And, so, for investment-grade bonds that are general
obligations, they can, you know, amount to up to 5 percent of
your highly liquid assets.
Senator Warner. The effect, I think, and I will again turn
it over to Senator Heller, is that you are, in effect, giving
sub-sovereign debt that may be European-based, does not have
the same level of restriction that American muni debt would
have. And, again, I understand the need to have that liquidity,
but it does seem to be a--and, you know, we are going to urge
you to reconsider or look at legislative solutions.
But, thank you, Senator Heller.
Senator Heller. [Presiding.] Senator, thank you.
As you probably heard, the bell went off for a vote down on
the floor, so as you can tell, I am the only one up here right
now. My job is to hold down the fort until they make themselves
back. I do not know if that is good news or bad news for you,
but I want to again thank you for your time and for your
expertise on this particular effort.
I would like to ask a question based on what you were just
talking about when it comes to liquidity. It seems to me, and
maybe you can answer this question, electronic trading seems to
have made the equity markets more liquid. Why does it appear
that it has made the debt markets less liquid? Is that----
Mr. Powell. I do not know that I would say it has made the
debt markets less liquid at all. I think the question really
is--these are new liquidity providers who are providing
liquidity in a different way, in a different form, in different
amounts, and at certainly a different speed than traditional
providers had. That does not mean that there is less liquidity.
I would not say that at all.
I think the question with the high-frequency traders is
when they become the dominant liquidity provider, is that
liquidity--and it is a question, it is not an answer, it is a
question--does that liquidity become somewhat more fragile,
more likely to disappear, as happened on October 15. That is
not to blame October 15 on the high-frequency trading firms,
but that is a question we have a responsibility to answer and
understand as it relates to this change in market structure.
Senator Heller. Thank you, Governor.
Let me quote from former Treasury Secretary Larry Summers.
He stated recently that there is a legitimate concern that
through your regulatory actions, you are losing sight of
keeping markets open and liquid. Can you respond to that, Mr.
Weiss.
Mr. Weiss. So, I believe what former Secretary Summers was
referring to was this so-called tradeoff between financial
institution stability and market stability, and I think as I
made clear in my opening remarks, our view is that this is
comparing two completely different environments, really, that
do not bear comparison.
The liquidity that was in place in 2005, 2006, and 2007 was
fueled by banks that were leveraged 40-to-1, 50-to-1, 30
percent short-term wholesale funding, substantial off-balance
sheet lending that came on-balance sheet, and the liquidity
conditions that exist today, however one may characterize them,
are far more stable as a result of all of the reforms that have
been made.
There was a letter from JPMorgan's CEO attached to the 2015
annual report, and I quote, he concluded, ``We may have had
artificially higher liquidity in the past and are returning
closer to normal.'' Now, that is not to say that there are not
profound changes taking place in the nature of liquidity
provision and the structure of fixed-income markets, but it is
important to note that the liquidity benchmark of pre-crisis
really should not apply to any future assessment, in our
judgment.
Senator Heller. So, do you believe or not believe it is
fair to question whether regulations are having a profound
impact on these fixed-income markets? From your testimony,
unlike the Governor's, I think you mentioned that taking a look
at these regulations may make some sense. Do you feel that the
regulations that are currently in place are doing exactly what
they intended to do?
Mr. Weiss. I think the prudential regulators, and I would
defer to them in the first instance, really have tailored
regulatory tools in order to differentiate between smaller
financial institutions, regional financial institutions, and
the largest ones, and the tailoring that is available to the
prudential regulators through the design of these rules,
coupled with the discretion which is afforded to prudential
regulators to develop--to react to developments in the
marketplace, you know, in our judgment gives the current
framework ample flexibility to address changing conditions.
Senator Heller. OK. So, let me ask you this as a follow-up.
Was it your intention through regulations to push banks out of
their traditional role of fixed-income market makers?
Mr. Weiss. As a matter of fact, the banks are still, you
know, a majority of market making, you know, both in
Treasuries, if one aggregates off-the-run securities and on-
the-run securities, and in corporate bonds, and are active
market makers as we speak in all fixed-income markets. And, so,
to the contrary, because----
Senator Heller. But you are not disagreeing that their
participation is decreasing?
Mr. Weiss. Their participation is still at the core of the
way fixed-income markets are intermediated.
Senator Heller. Well, the market participants themselves, I
think, may raise some questions to those comments, believing
that it is much more difficult for them to stay in these debt
markets with the regulations that are currently in place. Is
that a fair assessment on their part?
Mr. Weiss. I think market participants are adjusting to all
of the factors which Governor Powell highlighted and which I
have stated, and those include technology, changes in risk
appetite. They include, as well, changes in business models.
Different banks are pursuing different business models and
strategies. And, they reflect much needed reforms, which I
referred to in my opening comments.
But, I would like to go back to our premise. Liquidity
conditions as a whole in fixed-income markets, while evolving,
do not show on an evidence-based approach broad deterioration.
Senator Heller. OK. Governor, do you have any comments?
Mr. Powell. I am in the same place. I would agree with
that.
Senator Heller. At the end of your opening statement, you
talked about the Treasury Department looking for information,
asked for a request for information from industry participants.
What do you anticipate doing with that information?
Mr. Powell. So, this is Treasury's--it's Treasury's request
for information, but I will just say that we do not actually
have post-trade reporting that is available to any regulator on
a routine basis in the cash Treasury market, either on the
interdealer platforms or on the dealer to customer market. So,
doing the analysis to deal with one 12-minute trade event took
almost a year. It took several months to get an interagency
agreement. So, this is not where we need to be. I think for us
to do our jobs and provide the kind of oversight we need to
provide for these markets to assure the public that they are
safe and sound, I think we do need to have better information.
The question of what to do with it is also the subject, though,
of the Treasury's request for information.
Senator Heller. Yes. Would you follow up, please?
Mr. Weiss. I would concur with Governor Powell's comment
that it is clearly inadequate, given all of the technology
evolution that has taken place in cash Treasuries, for it to
take five supervisory agencies 9 months to put out a report
that is comprehensive on what took place October 15. And, I
would point out that if that report itself was really based on
only partial data, it was based on interdealer markets where we
had access to data, there was then the Federal Reserve Bank of
New York introduced a subsequent report a couple of months
later.
You know, all of that suggests that with transactions
happening in microseconds, the agencies which are charged with
overseeing these markets do need more robust access to data,
and we will have a plan in place by year end to assure that
that happens.
Senator Heller. Thank you very much.
I need to get down to the vote, so I will kick it over to
Senator Warren for now for her questions, and hopefully, the
Chairman will get back before she is done. Senator Warren.
Senator Warren. All right. Thank you.
So, thank you all for being here. Let us pick up on this
issue. Republicans have suggested that the changes in the law
to prevent another 2008 crash have undermined market liquidity,
and I just want to dig into what that really means.
Mr. Weiss, you wrote an op-ed in the Wall Street Journal
last year in which you noted that while there may have been
more liquidity before the crisis than there is now, quote,
``pre-crisis liquidity built on excessive leverage and unstable
funding turned out to be available in good times, but not in
bad. During the crisis, those inventories did little to prevent
the financial markets or the broader economy from freezing
up.'' And I think that is consistent with the testimony that
you have offered today.
I think this is a very interesting point, and what I want
to ask is whether you think that because of the new rules,
including Dodd-Frank, there is now a better chance that
liquidity will be available the next time there is panic in the
markets.
Mr. Weiss. So, Senator, that is really at the heart of the
question, and it is absolutely the case that pre-crisis
liquidity, for reasons that we have all stated, is a poor
benchmark for overall liquidity. And, it is our judgment that
however one wants to characterize liquidity conditions today,
and again, I think Governor Powell and I have given generally a
sense that liquidity is sufficient in fixed-income markets,
although there are those who argue to the contrary, but the
evidence again suggests it is within normal ranges, I do think
that what regulation has produced is a higher likelihood that
the liquidity conditions that exist today will be available
tomorrow in a period of stress.
Senator Warren. So, let me just underline that point and
make sure we are exactly on the same page. I do not want there
to be any ambiguity about this. Do you think that Dodd-Frank
and the ancillary rules have made financial markets more
resilient and better equipped to handle the kind of stress we
saw in 2008?
Mr. Weiss. Without a doubt.
Senator Warren. Thank you. You know, I think some of this
discussion of liquidity may miss the forest for the trees.
Liquidity that disappears exactly when the market needs it is
not very valuable. Our focus should be on ensuring liquidity
during times of stress, and it sounds like Dodd-Frank has
helped us do exactly that.
Now, while we are on the subject of liquidity, Governor
Powell, I wanted to ask you about the Fed's recently finalized
rule on the liquidity coverage ratio, and I think Senator
Warner may have started this while I was gone. As you know, the
liquidity coverage ratio is a joint requirement of the Fed, the
OCC, and the FDIC. It currently applies only to a small group
of the largest financial institutions, largest banks in the
country, and it requires those banks to hold a certain amount
of highly liquid assets. The idea is that the biggest banks
should have a minimum amount of liquidity so they can weather a
crisis without needing a bailout.
How much credit a bank gets for an asset depends on the
asset's liquidity. So, for example, cash and Treasuries are
considered Level 1 assets and they are given the most credit.
Fannie Mae and Freddie Mac securities are considered Level 2A
assets and given less credit than Level 1 assets. And then
certain highly liquid and marketable corporate debt securities
are considered Level 2B assets and given less credit than Level
2A assets. Originally, municipal debt was not given any credit
at all.
Now, the Fed recently changed this rule to allow certain
highly liquid and readily marketable municipal securities debt
to count as Level 2B assets. The Fed determined, however, that
municipal securities were not liquid enough to count as Level
2A assets.
So, my question is, can you explain why the Fed was more
comfortable counting certain municipal debt securities as Level
2B assets rather than Level 2A assets?
Mr. Powell. Yes, Senator. First, I think you accurately
stated the point, that the Level 1 assets are highly liquid,
highly reliably turned into cash in moments of stress when they
are needed to do so. Level 2B is the middle ground and it tends
to be the GSEs in our market. And Level 2B is----
Senator Warren. You meant 2A.
Mr. Powell. I am sorry, 2A. Level 2A is the GSEs,
effectively, and Level 2B is corporates, highly rated
corporates that have good liquidity. It just--it seemed to us,
and it seemed to me, in particular, as well, that investment-
grade munis that are general obligation bonds were more akin in
their liquidity, if you look at their actual liquidity trading
statistics, they were more akin to highly rated corporate bonds
than they were to, you know, the sub-sovereigns, which trade
almost like Treasuries.
Senator Warren. OK. Would you have concerns about liquidity
in a time of crisis if municipal debt securities were counted
as 2A Level assets instead of 2B Level assets?
Mr. Powell. I think that would give them too much credit.
You know, we have to make a judgment here, and I think they
are--in their liquidity characteristics, they are much more
like corporate bonds. We really want these large institutions
to have highly liquid assets. I do not think that munis qualify
to be 2A.
Senator Warren. OK. So, these characterizations are what
really go to the heart of the liquidity issues that we are
dealing with now, and making sure that the liquidity is there
when we really need it, which is also what we are trying to
accomplish here.
It is critically important that our biggest banks have
sufficient assets in a time of crisis and that those assets be
liquid, but it is also important that municipal bonds are
treated fairly under the new rules, and I appreciate your
perspective on how we try to get that balance. Thank you.
Thank you, Mr. Chairman.
Senator Crapo. [Presiding.] Thank you very much, Senator
Warren.
As you can see, a lot of the Senators have had to leave for
a vote. I do not know how many of them we will be seeing pulled
back here, because they all have multiple hearings and
activities today, but I am going to take the next round.
First, I want to get back into the topic we were discussing
before I had to yield my time for further questions earlier,
and I guess for both of you, I have a question. Do you have
concerns that the liquidity for corporate bonds that do not
necessarily trade in high frequency has deteriorated over the
past few years?
Mr. Weiss. I mean, this is something we are obviously
monitoring. I think, as has been mentioned, it is important to
break corporate bonds down into subcategories, and I will go
back to the fact that issuance has been strong, primary
issuance, over the whole 4-year period. In fact, a record has
been set for the category as a whole in each of those years,
and that volumes, trading volumes have also been strong.
What we have noticed by the evidence are two trends. One is
that there was a decline in the size of corporate bond trades
immediately following the crisis, and although it has picked up
somewhat, as the chart attached to my testimony shows. And the
second point is that there has been a decline in the proportion
of block trades, large transactions, and, therefore,
intermediaries and
investors are having to internalize and take greater
responsibility for achieving liquidity for larger transactions.
Senator Crapo. Governor Powell, did you want to add
anything to that?
Mr. Powell. Sure. So, I agree with that. I would add two
quick things. One is that we are now seeing a significant
number of electronic platforms springing up in the corporate
bond market for the first time, which would enable buyers and
sellers to meet, and that is a new thing which we will see if
it pans out. But, this is the kind of thing that is constantly
happening as these markets transition.
The second is corporate bond markets have been through,
really, two significant shocks in the last year, one of which
would be the significant decline in oil prices and the other of
which was really the global turmoil and recession fears and
that sort of thing that went through the market. And in both
cases, the corporate bond markets navigated through that with
pretty normal behavior. There was some increase in bid-ask
spreads and things like that, but very high volumes of trading
and really well within the historical range. So, we do not see
the kind of problems.
Senator Crapo. In your analysis, are you not seeing a
decrease in dealer inventories and a reduction in market-making
activities?
Mr. Weiss. I mean, I think I gave the figures previously
about dealer inventories were, in corporate bonds, by
independent estimates, at about $40 billion in 2005 and that
are about $20 billion in 2015, and that is relative to
outstanding levels of $5 trillion in 2005 and around $8.5
trillion in 2015. So, I think however you position the
numerator and the denominator, the outstanding has always been
well in excess of dealer inventories.
Senator Crapo. I want to get back into the question of
post-reform regulatory impact. I do not think there is any
question, as Senator Warren indicated in her questioning, that
following the post-regulatory, or the post-crisis regulatory
impact that we have--the reform impact that we have seen, that
we see greater leverage and higher quality of leverage in the
system, which is a good.
The question that I think that I see raised by a number of
those who are studying this is, and I think, Governor Powell,
you referenced this, there is a tradeoff, is there not, between
this regulatory safety and soundness that we are seeking to
achieve here and the liquidity in the markets. And the
question, is it not, whether we have achieved the right balance
in this process, or do you believe that we have reached the
right balance and that there is no issue here to evaluate?
Mr. Powell. Senator, I do not know that there is a
tradeoff, and I think, again--I do not want to look at the pre-
crisis levels of liquidity as any kind of a benchmark. So, we
are in a new world post-crisis where we are trying to
strengthen the core of the financial system, trying to
strengthen these firms, trying to make them less risky, and
that is having the effects that we have talked about--smaller
portfolios in some fixed-income securities and
others.
So, what you would worry about is that you would see the
capital markets not functioning well, not performing the
service they are supposed to perform for borrowers and lenders,
and we do not really see that. We see isolated examples of it,
but the case is really not made, in my mind, and I try to keep
up with this pretty carefully.
Senator Crapo. Well, I guess you may have answered this,
but I have not suggested that we should be comparing to pre-
crisis levels. What I am talking about is today and whether we
see an impact on liquidity in the markets, whether we see
market participation going down, market makers leaving the
market. And are you telling me that you are not seeing that?
Mr. Powell. I would say, by most measures, if you look
across a broad set of liquidity measures in most markets, you
really do not see--you cannot prove a broad decline in
liquidity as it really matters for buyers and sellers. You do
not see that big of a decrease in market depth. There is no
story to be told around bid-ask spreads, for example, which are
a key indicator of liquidity. In terms of the impact of trades
on price, which is a very important, probably the most
fundamental one, there is no clear trend there that would say,
yes, there is a liquidity problem here that is hurting the
financial markets and, hence, the economy.
Mr. Weiss. You know, if I could just build on that, there
is kind of a basic premise here, which is is it the case that
it is a law of nature that under all market conditions, all
market participants can sell large blocks of exposure without
impacting market price, and there is no such law of nature.
And, in fact, it has never been the case that under all
stressed conditions, there would be no movement in price.
And, there was a recent op-ed put out by PIMCO which was
articulate on this point, and what it concluded was, in
essence, that not all repricing events are themselves liquidity
events, and, you know, we agree with that.
Now, that being said, we do bear a real responsibility as
regulators and as agencies to monitor the liquidity conditions,
and in our judgment, the right reference period is not today's
liquidity conditions, and it is not the pre-crisis liquidity
conditions, it is potential liquidity conditions 5 years from
now and 10 years from now as technology evolves, as markets
evolve, as the world becomes more interconnected, and as we
anticipate future events of potential stress. And, the work
that we should be held accountable for is the anticipation of
those market conditions.
And, so, as I mentioned at the outset, we are heavily
engaged in a review of Treasury markets, which is the first
such Treasury market review since 1998. And, we are also
working at the FSOC in looking at asset management activities
and the questions that have been raised about underlying
liquidity conditions in mutual funds that may hold less liquid
assets and at the same time offer daily redemption.
And, so, our agenda is rather full looking forward. What we
would not advocate is to revisit the regulations that have been
put in place in the United States and globally which have
created
confidence in our financial institutions and solidity in our
liquidity conditions.
Senator Crapo. Well, so, you know, I have read most of the
studies that we have referenced here today, and it seemed to me
that in every one of them, a list of possible factors for the
issues we are dealing with was put out, and in every one of
them, if I
recall correctly, one of the issues that it was suggested we
need to look at was the regulatory climate and the impact and
the balance there. For example, the European Commission has
issued a call for evidence on the EU regulatory framework and
its impact on liquidity in these markets, to look at it and
study it.
I am afraid I am hearing you saying that you do not even
think we need to look at those kinds of issues because that is
not an issue. Is that what you are saying to me?
Mr. Powell. Senator, I think every study does consider the
question--every study I have seen--I have not read them all,
but I have read a lot of them--every study that I have seen
does consider the question and consider regulation as one of a
series of factors. I have not found any studies that think that
this is all about regulation----
Senator Crapo. No, I am not suggesting that, either.
Mr. Powell. No, I know you are not. I am just saying it is
clearly a factor, and, you know, some of that is by design,
frankly. You know, if you take, like, take the repo market, for
example, which is--there is no question, I think, that capital
requirements and prudential regulatory requirements generally
have raised the balance sheet costs of repo, and so there is an
effect in that market. But, what comes with that is significant
increases in safety and soundness.
Senator Crapo. And I understand that, and I do believe
there is a tradeoff in here. But, what I want to hear from the
two of you is that you recognize this is an issue and that you
are looking at it among the other issues that you are studying.
Mr. Weiss. Again, as I stated earlier, Senator, it is a
fair question. The response that I think you are hearing from
both of us is that liquidity provision in fixed-income markets
is evolving, that it is a period of historic change, that
technology, changing business models, changing risk appetite,
and much-needed regulatory reform are all playing a role in
that, that we have our work to do with the agenda that we have
set that is forward looking. And, again, I would underline, we
need to focus on where markets are headed in the future and the
potential for how those future markets may react to stress
events.
Senator Crapo. Well, thank you. I have gone way over my
time.
Senator Warren, do you want another round?
Senator Warren. Yes. Thank you very much, Mr. Chairman.
You know, let us pick up on this question about regulatory
climate and market security. Yesterday's announcement by the
FDIC and the Federal Reserve Bank that five of the largest
financial institutions in this country did not have credible
living wills is a clear statement that too-big-to-fail is still
a problem. The finding was that with these five financial
institutions, there is no credible plan in place that if they
start to get into financial trouble, that they will not bring
down the entire economy.
Now, many of the plans were found deficient because the
banks were said not to have sufficient liquidity in a crisis
situation. Governor Powell, could you talk for just a minute
about the role that liquidity played in the living-will
determinations?
Mr. Powell. Sure. So, we look at these, at all of these
plans across multiple dimensions, and that is one of them, and
it is a
different thing. Many of these firms have plenty of liquidity
for the ordinary course of events. This is really about having
a plan and having the right quantity of liquidity and having it
in the right places for that event, which we hope never comes,
that you actually have to be resolved. And, so, what we require
of them is to have a model that clearly estimates that and a
system throughout their, what can be very complicated global
structures, of placement of the liquidity and, really more
importantly, a way to think about it, are they thinking about
it correctly, and that kind of thing.
So, we identified deficiencies for a number of them and I
think we gave clear guidance as to what they need to do to
address that deficiency, and all the other deficiencies, for
that matter.
Senator Warren. You know, the giant banks want to advance
the story that they are over-regulated, but it seems to me that
the report yesterday on living wills demonstrates that, if
anything, today, they continue to be under-regulated. That is,
they pose significant threats to the entire economy, and I
think that is something we have to take into account when we
think about what regulations and what changes are needed going
forward.
I want to ask one more question and that is a question
about data. Both of you have said that the Government needs
more data to adequately oversee the Treasury markets. Mr.
Weiss, could you explain what kind of data you are lacking and
what kind of vulnerabilities it creates not to have those data.
Mr. Weiss. Yes, Senator. So, in the futures market, which
is centrally cleared through a single exchange in Treasuries,
there is ample visibility and access to data.
Cash Treasury markets are fragmented. We have access to
interdealer markets on request, which is what we produced in
the October 15 report. We have relatively less access to the
dealer to customer flows, which still account for, I should
highlight, a majority of trading activity in cash Treasuries.
And, so, what we believe is imperative, and it is the first
course of action we are going to pursue, is to have a concrete
plan in place that cannot be reversed by year end such that in
the future, if and when there is another event, it will not
take five agencies 9 months to put in place information sharing
agreements and compile data and release to the public further
analysis.
Senator Warren. So, I am hearing you say you are on the
path here, and by the end of the year, you will have in place
the ability to gather the data you need on an ongoing basis,
both the data you need and in a timely fashion to gather those
data, so that you will be able to make faster decisions about
liquidity and other shifts in the market, is that right?
Mr. Weiss. Senator, I think we will have a plan, and that
plan will lead to the gathering of the data----
Senator Warren. OK. So, you will have the plan. You just
will not have it executed by that point.
Mr. Weiss. Senator----
Senator Warren. You will have a plan.
Mr. Weiss. We will have a plan and it will happen.
Senator Warren. And, how long will it take for this to be
executed? Do you have any clue?
Mr. Weiss. Not long after year end.
Senator Warren. OK. All right. Not long after year end.
That sounds good. All right.
Senator Crapo. All right. Thank you, Senator Warren.
Senator Warner.
Senator Warner. I am trying to get the update on what I
missed.
Senator Warren. You missed some good stuff.
Senator Warner. Good stuff.
[Laughter.]
Senator Warner. I think, because I missed Senator Warren's
questions, but I would like to, maybe not right now, but come
back again to the muni bond conversation at some point. I, just
again, basically feel that the notion that foreign-based debt
is going to have a higher capital standard than American-based
equivalent debt is not the right way to proceed.
Let me--this is a little, kind of in the bucket that we are
in, but slightly off topic, an issue that I have discussed with
both of you a number of times, and that is the overall question
of our balance sheet and the $19 trillion of debt and the
effect, I think, that the rise in interest rates will have on
the Federal Government's ability to, frankly, invest in
anything in the discretionary realm.
I give the Fed a lot of credit, and others, for stepping up
when we as policymakers have not stepped up, but you are almost
out of tools. One tool that I would like your comments on,
Governor Powell, is inside our current debt portfolio at the
Federal level, I think the average duration of most of the bond
portfolio is about 69 months. Yet, if you look at the United
Kingdom, their average sovereign debt has terms of about 10
years. We have the longest term instrument we use, which is a
30-year instrument. Japan uses a 50-year instrument. Princeton
uses a 50-year instrument.
Has there been thought inside the Fed about looking toward,
you know, with interest rates at such record lows and,
unfortunately, us still borrowing at the rates we are, and
obviously everyone agrees that the deficit numbers are going
back up, looking at longer-term instruments in terms of locking
in more of this debt at these record low levels in terms of
interest?
Mr. Powell. Senator, that is very much a Treasury
Department question, if I may so. It is not something we have
responsibility for.
Senator Warner. You are right.
Mr. Weiss. It would have been a question of Governor Powell
20 years ago.
[Laughter.]
Senator Warner. And, I actually----
Mr. Weiss. I was going to ask Governor Powell to defer.
Senator Warner.----back to in his earlier private sector
experience, and then switch to you, Mr. Weiss.
Mr. Weiss. But, in any case, you know, so we look at this
constantly. We look at the composition and issuance of the
Federal debt constantly. You know, in the wake of the financial
crisis, the duration of the Federal bond portfolio was 49
months. We issued masses of bills at a time when there were two
wars and huge deficits following the Great Recession. That
number is, as you suggest, Senator Warner, now up to 69 months,
and our policy has really been to extend this.
We have two tenets we try to stick to at Treasury, which
are, on the one hand, to issue at the lowest cost possible over
time, and on the other hand, to be regular and predictable.
And, what this does underline is that Treasuries are different.
We do not introduce new instruments and then withdraw them. The
market views Treasuries as a risk-free asset. I mean, our
short-term rate is 19 basis points for 1-month bills now, 10
years at 1.75, long bond is at 2.6-something. So, we try to
issue and maintain low rates across the curve, and the
steadiness of issuance and the predictability of our issuance
is really a core tenet of----
Senator Warner. I guess I would just comment that when we
see--and, obviously, because of the depth of the Treasury
market, you need to have that predictability. I understand
that. But, when you look at similar, you know, the United
Kingdom having an average timeframe of 10-year framework, when
you look--I think Senator Crapo and I spent a long time on
balance sheet issues, and those debates have disappeared,
unfortunately, from most of the political discussion today, but
they are coming back. Any prediction, left or right, shows the
deficit going up dramatically, and the deficit really, my
belief is, is not necessarily the sole driver right now.
It is the challenge of the aggregate debt totals and the
effect of even relatively modest interest increase in rates has
an enormous effect in terms of decreasing the ability, again,
for this Government to have any kind of discretionary spend.
So, I just ask for further consideration on this.
Mr. Weiss. Senator, I would be happy to come with my team
and brief you in great detail, along with Senator Crapo. We do
have a policy of extending the maturity. There are some
limitations to how quickly that can be done. They stem from the
regular and predictable need for issuance, but also the fact
that our deficit has come down so dramatically in the last few
years. But, I would be happy to go through----
Senator Warner. Which is also starting to ramp back up.
Mr. Weiss. But at the same time, given the $13 trillion of
marketable securities, the ultimate duration of that portfolio
does not change quickly.
Senator Warner. I would love to have that brief.
Thank you, Mr. Chairman.
Mr. Weiss. Happy to do it.
Senator Crapo. Senator Heller.
Senator Heller. Mr. Chairman, thank you.
I will mention that I am probably less than satisfied with
the direction this particular hearing is going. I am more
concerned that here on this panel, most of us on this panel are
concerned about the liquidity of these markets, and yet with
regulators in front of us, I feel that the only message that I
am really getting from them, that there is nothing wrong with
the debt market. Yet, the market participants are all concerned
that we have seen some dips and some volatility in these
markets that we should be concerned about. And, my concern
about it is we have got two regulators in front of us that,
frankly, do not share the concern that market participants have
about the viability of long-term debt.
I will give you ample time, if you need it, to share with
us, but hearing from our witnesses today, outside of one
cheerleader here on our side, that, frankly, most market
participants are very, very concerned about the long-term
viability of our debt market. So, maybe I can try again.
Let me ask you this question. Do either of you believe that
ultra-low interest rates and perhaps quantitative easing is
masking some of the impacts that we have on reduced market
liquidity?
Mr. Powell. I guess I should take that. So, I think very
low interest rates have been a big factor in promoting primary
issuance, which has been at record levels and greatly expanded.
Any company that could finance has financed and certainly
should have done by now. So, I do not think that has masked--I
would not say that it is masking liquidity.
I guess the question I would worry about is what will
happen as the process of raising interest rates goes on. And,
that will happen in a changed marketplace, it is very fair to
say, and in that marketplace, asset managers, asset holders are
going to bear more of the liquidity risk, because the dealers,
however much they were bearing before, are going to be bearing
less, although it is not clear that they were really going to
be there in stress, anyway, for the corporate bond market.
So, the question there is, are the asset holders, mutual
funds, HFTs, hedge funds, and the like, are they going to be
able to deal with stressed market conditions if they arise, and
in any case, with a higher rate environment. So, I think those
companies need to focus on that, and if you talk to the big
asset managers, they are very focused on this. They are very
focused on having enough liquidity on hand and on being ready
to manage this new and changing environment, which is very
different from the pre-crisis environment.
Senator Heller. Mr. Weiss.
Mr. Weiss. I would concur with Governor Powell. As to our
level of focus on this topic, it is intense. I would say it is
among our top priorities at Treasury to understand the evolving
nature of fixed-income markets. This is why we commissioned and
published the joint staff report which was made public in July
of last year on Treasury markets, and it is also why we have
initiated the first fundamental review of secondary markets in
Treasuries since 1998. We feel an awesome responsibility to
maintain the depth and liquidity of this vital market, you
know, not just for today, but for the decades ahead.
Senator Heller. Changing subjects just a little bit here,
in your review of the global regulatory markets and the rules
that are out there in order to--frankly, are you reviewing some
of these global rules in order to avoid some of the harmful
liquidity that we have, may have, or has occurred or may occur
here in the United States? Mr. Weiss.
Mr. Weiss. I mean, I would defer to Governor Powell.
Mr. Powell. I am sorry. Which rules, Senator?
Senator Heller. Basel.
Mr. Powell. The Basel rules, OK. I guess I would say it
this way. We are--I am, and I think we are, and I know Treasury
is, as well, very focused on conditions in fixed-income
markets, and that includes Treasury, cash markets, and futures,
and it includes the corporate bond markets, investment grade,
non-investment grade, and such.
Senator Heller. Do you think capitalization has any effect
on liquidity?
Mr. Powell. I do think capital requirements--the capital
requirements that we have imposed on the largest financial
institutions have raised the cost of balance sheet. They have
made balance sheet heavy businesses more expensive for them to
run, and undoubtedly that is one of the reasons why they have--
running smaller balance sheet. Repo would be sort of the center
of the bull's-eye on that for me. So, yes, there will have been
an effect there. But, I would say again, it is not an effect
that was unintended and we do not think it has negative
consequences, particularly, that cannot be dealt with in an
evolving marketplace.
Senator Heller. Mr. Chairman, thank you.
Senator Crapo. Thank you, Senator Heller.
I have just got a couple more questions, and then we will
see if anybody else wants to----
Senator Warner. Mr. Chairman, I am going to have to leave,
but I am going to leave Senator Warren to ably----
Senator Crapo. In charge. All right. Very well. That will
just reduce the number of questions.
Senator Warren. But not the intensity.
Senator Crapo. Not the intensity.
[Laughter.]
Senator Crapo. I am just going to come at this one more
time from a different direction, and I am going to talk--let us
talk about liquidity risk. In one of the New York Fed's
research posts entitled, ``Has Liquidity Risk in the Treasury
and Equity Markets Increased?,'' the authors noted that,
frankly, liquidity risk has risen, and I am going to just quote
an excerpt and ask for your reaction to this. This is a quote:
While current levels of liquidity appear similar to those
observed before the crisis, the sudden spikes in illiquidity,
like the equity market flash crash of 2010, the recent equity
market volatility on August 24, and the flash rally in Treasury
yields on October 15, 2014, seem to have become more common.
Our findings suggest a tradeoff between liquidity levels and
liquidity risk. While equity and Treasury markets have been
highly liquid in recent years, liquidity risk appears elevated.
Do you agree with that?
Mr. Weiss. In fact, that is one of the areas in our request
for information where we pose a whole set of questions, and it
has very much to do with the evolution in market structure.
Equities started to be traded primarily algorithmically, as you
know, in the 1990s. That then moved to FX and to futures and it
began in Treasuries in around 2003. This creates a new
paradigm. The speed of markets today is measured in
microseconds, as you know, and the difference between the
equity market hearing which you held, I think it was a month
ago, and the discussion of Treasuries is a difference in kind,
not of degree.
When the market structure changes that radically for
Treasuries, which are a benchmark security, although we have
not noted an impact on trading volumes or the ability to issue
debt or the ability to transact, we do need to look forward and
to make sure that the operational risk measures that need to be
in place are strong and that the protections against practices
which have arisen in other markets are strong, as well. And,
so, our whole effort is made to be forward looking and to
assure that those safeguards are in place for our deepest
market.
Senator Crapo. Governor Powell.
Mr. Powell. I cited that and referred to that in my
testimony, so I do not think you can take any single piece of
research as wholly dispositive. It is probably a good idea not
to. But, nonetheless, I found that to be persuasive. And, I
would just point out that they found no such effects in the
corporate bond market. And, as I was referring to earlier--that
is where you would expect to find these problems, because that
is where prudentially regulated firms do their business, the
on-the-run interdealer platform is so entirely electronic, that
story of what is happening there is really not about prudential
capital requirements. It is about what is going on with trading
at billions of seconds and how that affects liquidity.
Senator Crapo. All right. Thank you.
I will just conclude on this aspect before I go to my last
question, which is a wholly different topic, by saying I
appreciate the investigation and the activity that you have
already engaged in. I am heartened by the request for
information, and I just encourage and hope that you will look
at all potential aspects of the cause of the issues that we are
dealing here with regarding liquidity in the fixed-income
markets.
I am going to just go into one other question really fast.
I hope I do not open up a whole big discussion by this, because
I do not think this is going to be controversial, but earlier
this week, the Government Accountability Office released its
report, which Senator Warren has referenced, with regard to its
recommendations on improving the transparency and timeliness of
the Federal Reserve and the FDIC living-will process. I guess
this question is going to be for you, Governor Powell.
The credibility of the living-will process was undermined
that very same day when the results of the Federal Reserve and
FDIC living wills were leaked to the press the day before they
were made public, and my question has to do with that leak.
Whatever one thinks of the results of the living-wills process,
this is not how the process is supposed to play out, and it
shows that the process needs to be reformed. Something is
wrong.
And, so, my question is, Governor Powell, do you expect
that the Inspectors General of the Federal Reserve and the FDIC
will be tasked with finding the source of this leak and how
this leak could have occurred?
Mr. Powell. Senator, let me say that I am very troubled by
the leak, and I think both at the FDIC and at the Fed, the
matter has been referred to the Inspector Generals. I would
add, if I may, that the GAO report--offered some things that
are well worth
considering around--and I think we have actually followed
through on some of those recommendations already.
Senator Crapo. All right. Thank you.
I note that Governor--I mean, that Senator Rounds has
joined us. I do not know if you have any questions----
Senator Rounds. I do, and thank you for the compliment,
Senator.
[Laughter.]
Senator Rounds. I do have just a few, if----
Senator Crapo. If you would like. We will do that.
Senator Rounds. Thank you, and just a couple. I apologize
for not being here. I had floor duty today, so that takes
precedence.
I know that the issues that we are talking about, they are
very important, and that there was a real question that
occurred during this particular event back in October of 2014.
Specifically, though, I understand that Senator Warner had some
specific questions on high-quality liquid municipal bonds. We
have been discussing these issues, and I think it is an
important issue that needs to be addressed.
So, my question today is, with the fact that these
Treasuries make up a significant part of the total bond, but
there are other types of bonds, as well, that are also
important, does this event support the argument that banks
should be incentivized to hold a wide variety of potentially
liquid capital rather than concentrate their liquid capital in
assets such as Treasuries, and in particular, we are thinking
of municipals and so forth. Would you care to comment on that?
Mr. Powell. I guess that is probably for me, Senator.
Senator Rounds. Please, yes.
Mr. Powell. The liquidity coverage ratio requires that you
have a certain amount of liquid assets to cover a 30-day
outflow in stress conditions and it counts different securities
that have different levels of liquidity at different----
Senator Rounds. Two-A, 2B----
Mr. Powell. Right. You have got it. So, we put them in 2B.
I think the other regulators did not want to count them at
all----
Senator Rounds. Right.
Mr. Powell.----and are not counting them at all, so we are
counting them to some extent. It does not in any way limit the
ability of a financial institution from holding more than that.
It just does not count in liquidity coverage ratio, that is
all. And the reason that they are in that bucket is that they
are just a little less liquid, or significantly less liquid,
than the 2A assets.
Senator Rounds. But, is there enough--and, once again, I
understand that you have identified and have accepted 2B.
Someone said is it 2B or not 2B, and I think 2B is better than
not at all----
[Laughter.]
Senator Rounds.----but, nonetheless, you are one of the
organizations, not all--my question is, just in terms of a
discussion on it, it seems to me that there is a logic behind
promoting not just Treasuries, and it seems to me that having
other types, and this particular event that occurred in October
of 2014 seems to bring that to the forefront, that there are
other types of securities besides Treasuries that are also
very, very valid and that should be
considered. And, I guess I am using this as a way to point that
out, and any other comments you may have, I would appreciate.
Mr. Powell. So, I would agree. We do not want our banks to
turn into Government mutual funds, where they hold only
Government securities. That is not the intention. That is not
the plan. It would be highly undesirable because we need them
to be making loans and intermediating credit in our economy,
performing the role that they are supposed to perform. So, that
is not what we are trying to achieve with this at all, and, I
think, certainly not what we are--what any part of our
supervisory or regulatory program is aimed at.
Senator Rounds. I also understand that I have come into
this meeting late today, and you have been working on it
already, but I understand that the need for stronger capital
standards, but do you ever worry that requiring banks to hold
more and more capital may have unintended consequences?
Mr. Powell. Yes. We try to set the levels--when we make a
proposal for capital requirements, we put it out in a Notice of
Proposed Rulemaking and we get plenty of comments and we
consider them very carefully. We do. We try very hard to
calibrate these things at the right level to take into
consideration all of the things that matter. With the very
largest institutions, there is a surcharge that they have which
is supposed to really force them to internalize the cost of
their systemic-ness, if you will. So, you know, it is a
constant concern that we do the right level, certainly not too
little, but we are also not trying to do too much.
Mr. Weiss. I think we know that the wrong level was the
level of capital that existed in 2006 and 2007, when banks and
investment banks were capitalized at 40-to-1 or 50-to-1, with
large amounts of off-balance sheet financial leverage and an
over-reliance on short-term wholesale funding. And, so, that
has now been remediated through the prudential standards that
have been put in place, and we now know that in periods of
volatility, and I would not suggest that the last 9 months have
been a stress event, but I would suggest that they have been
highly volatile market conditions as market participants would
say, that we heard a lot about oil markets and structured--and
credit markets. We heard nothing about the health of our
financial institutions and we heard nothing anecdotally about
hedge funds who are unable to deliver on margin calls. And, so,
the solidity that we have built into our financial institutions
really does confer on the broader market a level of confidence
that we cannot take for granted.
Senator Rounds. Thank you, gentlemen.
Thank you, Mr. Chairman.
Senator Crapo. Thank you, Senator Rounds.
And, I think we are done with questions.
Senator Warren. Can I just say one thing, Mr. Chairman----
Senator Crapo. Sure.
Senator Warren.----just because of Mr. Weiss' last comment
and Senator Rounds' comment about the unintended consequences
of higher capital reserves, the fact that you say over the last
9 months we have heard nothing about the health of our largest
financial institutions. We just got a report yesterday from the
Federal Reserve Bank and the FDIC that there are five banks in
America that are too big to fail. And if we have a regulatory
problem, what that suggests to me is the regulatory problem is
we still have not done enough in terms of capital reserve, in
terms of regulation, in terms of making sure that these banks
are reined in and do not put the rest of the economy at risk.
The report is there. And, the report makes it clear. We are
all at risk, not because of over-regulation, but because of
under-regulation of the biggest financial institutions.
That is it for me, Mr. Chairman.
Senator Crapo. Senator Rounds.
Senator Rounds. And I think it is a healthy discussion to
have. The important part, I think, is that when we take a look
at making changes in it, naturally, there is a reason why they
settle on a particular number. I do not think any number is
perfect. I think the question becomes, talk to us about how you
come up with the numbers involved and what type of analysis is
done, and then as you move through and you learn, go up, go
down, but when you analyze them, what is the process in place
in order to do that.
And, I think it is healthy to have that discussion, because
if you require more capital, then that is money that is not
going to be available for other resources. And, that does not
mean that we have a perfect number at any point in the process.
And, while we want stability within the market, we also want
those regulators to have a process that the individuals, the
institutions that are being regulated understand and have the
opportunity to give positive input in making changes in the
future.
And, that is the reason why I ask. I just do not simply
think that one determining time period, one decision should be
infallible. And, so, I like the idea of being able to revisit,
and the idea of being able to have that on an ongoing basis,
but in a stable manner, one in which the members have a
process, the institutions understand the process, and there is
input which makes for a better decisionmaking process. That is
the reason why I asked the question.
Senator Warren. And I very much appreciate that, that we
have to have the right process in place. But we also have to
pay attention to the fact it is now 8 years after a crash that
brought us to the edge of economic oblivion. And what the Fed
and the FDIC are saying very publicly today is that we have at
least five too-big-to-fail banks in this country, that if any
one of them starts to go down, they risk taking the entire
economy with them.
And that tells me, you are right, we need to keep checking,
but the place we need to keep pushing is we need to keep
pushing on tougher regulations over these financial
institutions. They come to Congress and want to lobby us on,
oh, it is too tough, and let me tell you why it is too costly
and we want fewer, fewer, fewer regulations. But the reality
is, they put everybody else at risk when they are not properly
supervised.
Senator Rounds. It is good to have the give and take.
Senator Crapo. I was about to wrap it up. I was going to
take the last word, and I still will, but I am going to go to
Senator Reed, if you have some questions, Senator Reed.
Senator Reed. Thank you very much, Mr. Chairman, and thank
you, Senator Warren, for making sure I--no, thanks.
[Laughter.]
Senator Reed. I am going to be, I hope, succinct. Thank
you, gentlemen, for your wonderful testimony.
It struck me as we talked about the liquidity of
Treasuries, particularly, that there are many factors, and you
describe them, the market structure, et cetera, but one factor
which Mr. Weiss
highlighted in his comments, at the Federal Reserve back in
2015, is the debate here about the debt ceiling, about
suggesting that we might not respond favorably to--can you
comment about that as a factor that would affect liquidity or
market activity with Treasuries.
Mr. Weiss. Well, I have lived through one debt ceiling from
inside Treasury and I can confirm that it is truly scary from
inside the institution. Fortunately, Congress worked with the
administration to agree to a 2-year budget deal which also
dealt with the debt ceiling in that particular period, but,
Senator, you are quite right. If you look back at 2013, and
2013 was different in that there was a Government shutdown, as
well, but consumer confidence declined by, I think it was 12
percent. The S&P traded off. The U.S. had its sovereign debt
rating downgraded. And there are some estimates that GDP growth
was cut by as much as a half-a-percentage point, a half-a-
percentage point which is hard to recover.
And, so, all I can say, Senator, is I hope that following
the smooth process that was in place at this past year end,
that we not revisit these kinds of self-inflicted wounds due to
the breadth of damage they do to the economy.
Senator Reed. Just a final very quick point, too. As I
would assume that you were trying to count, figure out what
would happen to Treasuries in that situation, because it is
uncharted terrain, and mercifully we did not get there, but for
a moment, it looked as if all the rules would be erased and you
would have these----
Mr. Weiss. Absolutely. As Governor Powell will remember
from his time at Treasury, we had our fiscal teams and our debt
management teams in hourly standby to deal with every possible
eventuality.
Senator Reed. Thank you.
And, Governor Powell, again, thank you, not only for your
testimony, but for your service for the many years. We
appreciate it.
One of the points that you made in your testimony and also
in your comments is about the role of high-frequency trading on
October 15, 2014. I know my colleagues have been asking
questions, but do you have any further thoughts about high-
frequency trading and its effect on the crash or its ongoing
sort of challenges?
Mr. Powell. Senator, I just would say that it is here to
stay. Electronic trading, algorithmic trading is now very
prevalent in the equity markets and in the interdealer part of
the Treasury market. It is enabled by technology and
telecommunications, and we need to know that it is here to stay
and we need to make sure that it takes part in these markets in
a way that protects the safety and soundness and allows the
public to retain confidence. And, that is just how we look at
it, and I think it is--I would not blame the events of October
15----
Senator Reed. No----
Mr. Powell. I would not, and I know you did not.
Senator Reed. Right.
Mr. Powell. But, nonetheless, I think our obligation is to
understand the evolution of these markets and make sure that
the public has a basis for continued confidence.
Senator Reed. And, I have one final question for both of
you. We all, or many of us engaged--Senator Crapo particularly
was an
incredibly thoughtful, active Member of the Committee when we
passed the Dodd-Frank reforms. I know there are things we would
like to rearrange, change, improve, et cetera. But, by and
large, do you have a sense of whether they are helping to
stabilize the financial institutions in a positive way?
Governor Powell first.
Mr. Powell. I think it is, to me, very clear that financial
institutions are much stronger, safer, sounder, more resilient,
better capitalized, more liquidity, less risky, and all of
those things than they were before the financial crisis and
Dodd-Frank certainly gets some of the credit for that.
Senator Reed. Thank you, Governor.
Mr. Weiss, please.
Mr. Weiss. You know, it is undoubtedly the case. It is also
the case that we have work cut out for us and this is why we
have issued our request for information on Treasury markets. It
is also why the FSOC is looking into issues of liquidity and
redemption risk in certain asset management activities. So, I
would not want to say that we are satisfied. There is plenty of
work to do, but as to the past, those regulations have stood us
in good stead.
Senator Reed. Just a final point. In your research now, I
hope you can fully engage OFR----
Mr. Weiss. Absolutely. OFR will be central.
Senator Reed.----and do it in a very positive, constructive
way. That would be another aspect of Dodd-Frank that could be
very productive.
Thank you, Mr. Chairman. Thank you for waiting for me.
Senator Crapo. Well, thank you, Senator.
So, let me wrap this up. You know, toward the end of the
hearing today, and actually throughout the hearing, we had
several occasions when the question of what is the appropriate
level of regulation has arisen, and I would just like to throw
in my two cents before I rap the gavel.
Undoubtedly, as I said in my opening statement, and as you
just both have reiterated, our financial institutions are
stronger, safer, sounder, better capitalized with higher
quality capital than they were before the crisis, and that is a
positive development.
I personally believe that, and as I indicated to you,
Governor Powell, from my reading of the studies that have been
done with regard to our fixed-income markets and the question
of whether we have a liquidity risk increasing in those
markets, that one of the factors that has been identified, I
think by every entity that has studied it, is whether the--and
this is not just the capital regulatory issue. It is whether
the cumulative effect of regulations by the different
regulators on the different aspects of the financial system is
creating liquidity risk.
And, I think, first and foremost, we need to recognize, I
believe, that there is a tradeoff, and it is a tradeoff that is
one we need to make. We need to understand it and we need to
reach the right levels of tradeoff in these decisions.
And, so, while we can all have different opinions about
what may or may not be the right level of capital that is
required, the right level of leverage, the right qualities of
capital, or as we go on to increasing issues that are covered
in the regulatory system, to me, the point that I would like to
make is, and I hope that you are doing this, is that we have
got to look at these issues and evaluate what the causes are--
that is what your request for information is seeking to do--
evaluate what the causes are if there is a liquidity risk issue
in these markets, and then identify those causes and then make
a decision as to whether those causes can be remedied or
whether there is other risk or danger that would be created by
proposed or by adjustments in those.
That is the kind of decision that we need to engage in, and
so--and you are the experts. You are the ones who are charged,
along with some of the other regulators, to make these
evaluations and assure that our system is promoting the maximum
safety and soundness that we can achieve with a recognition of
the impacts on liquidity and other impacts on our markets that
are caused by that.
That is what I am trying to get at here, and I am very
hopeful that as you go forward in your analysis, that you will
take those into consideration. We will probably continue to
have political debates about this for a long time, but what we
hope to see is that our regulators will continue to review
their own activities in terms of the impacts of their
activities on these markets and make sure we get that balance
right.
I am just going to make one other observation here. I think
you are aware, we have a Federal law that requires some of our
regulators to review their own regulations on a regular basis,
the EGRPRA process. Not all of our Federal regulators or
financial regulators are subject to EGRPRA. I have got a bill
that says that all of them should be subject to EGRPRA, simply
because of the principle that we should always be reviewing the
status of our regulatory system and the legal system that we
put into place to assure that we have safety and soundness and
vibrant and strong markets.
So, with that, I want to thank you both for being here. I
appreciate the attention you are giving to these issues. I am
sure that you will continue to get a lot of input from the
members of this panel as you move forward, and we look forward
with anticipation to the outcome of your analysis.
Mr. Weiss. Thank you. We would be happy to come and share
the outcome of the RFI when it is complete.
Senator Crapo. Thank you. This hearing is adjourned.
Mr. Powell. Thanks very much.
[Whereupon, at 11:45 a.m., the hearing were adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF JEROME H. POWELL
Member, Board of Governors of the Federal Reserve System
April 14, 2016
Chairmen Crapo and Heller, Ranking Members Warner and Warren, other
Subcommittee Members, I would like to thank you for inviting me to
testify today on trends in fixed-income markets. Because these markets
perform important functions in our economy, it is imperative that we
understand the significant changes they are currently undergoing. As I
will discuss, a number of factors have been driving these changes.
Some market participants have expressed concerns about low
liquidity across fixed-income markets, although many recent studies
have found it difficult to identify such a broad reduction. It may be
that liquidity has deteriorated only in certain market segments. It may
also be that, even if liquidity is adequate in normal conditions, it
has become more fragile, or prone to disappearing under stress.
The sharp swing in Treasury prices that took place on October 15,
2014, led the Federal Reserve Board, in conjunction with the Treasury
Department, the Commodity Futures Trading Commission, the Federal
Reserve Bank of New York, and the Securities and Exchange Commission,
to create a Joint Staff Report and to host a conference on the
structure of Treasury markets at the Federal Reserve Bank of New York
(FRBNY) in October 2015.\1\ The staff of the four agencies and the
FRBNY compiled transactions data across both Treasury cash and futures
markets and analyzed the factors that could have caused the rapid rise
and subsequent reversal in Treasury prices in such a short span of
time. This analysis did not find a single factor that caused the sharp
swing in prices.
---------------------------------------------------------------------------
\1\ See Joint Staff Report: The U.S. Treasury Market on October 15,
2014, U.S. Department of the Treasury, Board of Governors of the
Federal Reserve System, Federal Reserve Bank of New York, U.S.
Securities and Exchange Commission, U.S. Commodity Futures Trading
Commission, July 13, 2015, www.treasury.gov/press-center/press-
releases/Documents/Joint_Staff_Report
_Treasury_10-15-2015.pdf, and Conference Summary: The Evolving
Structure of the U.S. Treasury Market (October 20-21, 2015), Federal
Reserve Bank of New York, October 20, 2015, www.newyorkfed.org/
medialibrary/media/newsevents/events/markets/2015/Conference-
Summary.pdf.
---------------------------------------------------------------------------
As had already occurred in equity markets, advances in computing
and communications technologies have allowed proprietary trading firms
(PTFs, also often called high-frequency trading firms) to capture a
majority of the interdealer market in Treasuries. As a consequence of
these changes, trading in Treasury markets now moves at extreme speed.
It may be that these changes have also led to greater liquidity risk,
or sudden declines in liquidity. Researchers at the FRBNY have shown
that spikes in volatility and sudden declines in liquidity have become
more frequent in both Treasury and equity markets.\2\ There is also
evidence that liquidity shifts more rapidly and hence is less
predictable in these markets.\3\ In contrast, researchers have not
found evidence of these behaviors in corporate bond markets, where
traditional dealers still intermediate most trades and there is much
less high-frequency trading.\4\
---------------------------------------------------------------------------
\2\ See Tobias Adrian, Michael Fleming, Daniel Stackman, and Erik
Vogt, Has Liquidity Risk in the Treasury and Equity Markets Increased?,
Liberty Street Economics (blog), October 6, 2015, http://
libertystreeteconomics.newyorkfed.org/2015/10/has-liquidity-risk-in-
the-treasury-and-equity-markets-increased.html#.Vv7UvOab-p0.
\3\ See Dobrislav Dobrev and Ernst Schaumburg, The Liquidity
Mirage, Liberty Street Economics (blog), October 9, 2015, http://
libertystreeteconomics.newyorkfed.org/2015/10/the-liquidity-
mirage-.html#.Vv7Woeab-p0.
\4\ See Tobias Adrian, Michael Fleming, Or Shachar, Daniel
Stackman, and Erik Vogt, Has Liquidity Risk in the Corporate Bond
Market Increased?, Liberty Street Economics (blog), October 6, 2015,
http://libertystreeteconomics.newyorkfed.org/2015/10/has-liquidity-
risk-in-the-corpor-
ate-bond-market-increased.html#.Vwu8_Oab-p0.
---------------------------------------------------------------------------
Apart from such episodes of sudden volatility, questions about
whether liquidity in fixed-income markets has broadly deteriorated are
difficult to answer definitively. In exploring these topics, it is
important to distinguish between Treasury and corporate bond markets,
which have different characteristics.
In Treasury markets, traditional measures of liquidity, such as
bid-ask spreads, have been fairly stable in recent years.\5\ But the
changing market structure has also meant smaller average trade
sizes,\6\ and participants now must break up their larger trades and
employ complicated strategies in order to avoid moving prices.
Accurately measuring the effect of trading on prices, perhaps the most
fundamental gauge of market liquidity, can be quite difficult in such
an environment.\7\ There are also differences between on-the-run
Treasury securities, the securities that were most recently issued and
that are the most liquid, and off-the-run Treasury securities. However,
observable measures such as the spread between on- and off-the-run
Treasury securities do not show any trend change in liquidity between
the two market segments since the financial crisis.
---------------------------------------------------------------------------
\5\ See Tobias Adrian, Michael Fleming, Daniel Stackman, and Erik
Vogt, Has U.S. Treasury Market Liquidity Deteriorated?, Liberty Street
Economics (blog), August 17, 2015, http://
libertystreeteconomics.newyorkfed.org/2015/08/has-us-treasury-market-
liquidity-deteriorated.
html#.Vv7HQDP2bT4.
\6\ Ibid.
\7\ See for example, Terrence Hendershott, Charles M. Jones, and
Albert J. Menkveld, ``Implementation Shortfall with Transitory Price
Effects,'' in High Frequency Trading; New Realities for Trades, Markets
and Regulators, David Easley, Marcos Lopez de Prado, and Maureen O'Hara
(editors), Risk Books (London: 2013), http://albertjmenkveld.org/
public/papers/chapter_ELOv5.pdf.
---------------------------------------------------------------------------
In corporate bond markets, estimated bid-ask spreads have declined,
indicating that, if anything, liquidity may have improved.\8\ However,
given the nature of the corporate bond market, these estimates are
based on transactions rather than on direct observations of quotes to
buy or sell these bonds. What we can directly observe is that trade
sizes and turnover have declined in the most actively traded corporate
bonds as they have in Treasury markets.\9\ And although observable
measures of overall liquidity in corporate bond markets appear good,
there is some evidence that liquidity has deteriorated for the lowest-
rated bonds.\10\ Trading in these less liquid segments may rely heavily
on intermediation by dealers, and dealers have scaled back their
capital commitments and inventories in corporate bonds since the
financial crisis.\11\
---------------------------------------------------------------------------
\8\ See Bruce Mizrach, ``Analysis of Corporate Bond Liquidity,''
Financial Industry Regulatory Authority (FINRA), Office of the Chief
Economist Research Note, December 2015, www.finra.org/sites/default/
files/OCE_researchnote_liquidity_2015_12.pdf.
\9\ Ibid.
\10\ See Tobias Adrian, Michael Fleming, Erik Vogt, and Zachary
Wojtowicz, Further Analysis of Corporate Bond Market Liquidity, Liberty
Street Economics (blog), February 10, 2016,
http://libertystreeteconomics.newyorkfed.org/2016/02/further-analysis-
of-corporate-bond-market-liquidity.html#.Vv7ZcOab-p0.
\11\ See Hendrik Bessembinder, Stacey E. Jacobsen, William F.
Maxwell, and Kumar Venkataraman, Capital Commitment and Illiquidity in
Corporate Bonds, Social Science Research Network (SSRN), March 21,
2016, http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=2752610.
---------------------------------------------------------------------------
Immediately after the financial crisis, dealers began to move away
from a principal model of market making, whereby they would facilitate
trades using their own inventories and assume some risk, toward an
agency model. Many point to post-crisis regulation as a key factor in
this process. One area in particular where market participants point to
the impact of regulation is Treasury repo markets. At the 2015
conference, participants noted that required spreads on Treasury repo
trades have widened significantly since the crisis and attributed some
of this increase to regulation.\12\
---------------------------------------------------------------------------
\12\ Conference Summary: The Evolving Structure of the U.S.
Treasury Market (October 20-21, 2015), Federal Reserve Bank of New
York, 2015, www.newyorkfed.org/medialibrary/media/newsevents/events/
markets/2015/Conference-Summary.pdf.
---------------------------------------------------------------------------
But post-crisis regulations have also greatly strengthened the
major banks and made another financial crisis far less likely. Evidence
also indicates that certain regulations have increased liquidity; for
example, the mandate that more standardized derivatives be traded on
organized exchanges or platforms appears to have improved market
functioning.\13\ My view is that these regulations are new, and we
should be willing to adjust them as we learn. That said, we should also
recognize that some reduction in market liquidity is a cost worth
paying in helping to make the overall financial system significantly
safer.
---------------------------------------------------------------------------
\13\ See Evangelos Benos, Richard Payne, and Michalis Vasios,
Centralized trading, transparency and interest rate swap market
liquidity: evidence from the implementation of the Dodd-Frank Act, Bank
of England, Staff Working Paper No. 580, January 15, 2016,
www.bankofengland.co.uk/research/Documents/workingpapers/2016/
swp580.pdf.
---------------------------------------------------------------------------
It is important, however, not to overemphasize any effects of
regulation. Banks have independently recalibrated their own approaches
to risk and scaled back their market-making activities. Dealers
significantly reduced their fixed-income portfolios beginning in 2009,
well ahead of most post-crisis changes in regulation.\14\
---------------------------------------------------------------------------
\14\ See Tobias Adrian, Michael Fleming, Daniel Stackman, and Erik
Vogt, What's Driving Dealer Balance Sheet Stagnation?, Liberty Street
Economics (blog), August 21, 2015, http://
libertystreeteconomics.newyorkfed.org/2015/08/whats-driving-dealer-
balance-sheet-stagnation.
html#.Vwz69Oab-p0.
---------------------------------------------------------------------------
Corporate debt issuance has been at record levels in recent years.
With dealer balance sheets shrinking, buy-side investors now bear
greater liquidity risk. It is important that mutual funds and other
investors in fixed-income securities continue to take measures to
understand and manage these risks. In addition, we should
distinguish between systemic risk and market risk. The risks to
investors generally represent market risk and do not appear to pose
risks to the financial system as a whole. The movement of these risks
away from the Nation's most systemically important financial
institutions is one of many reasons that they are far stronger and more
resilient than before the crisis.
Markets are adapting to this new environment. Where there is an
unmet demand for liquidity, new market makers are emerging to meet that
demand. For example, some PTFs are seeking entry to dealer-to-customer
platforms for Treasury trading. Seven new electronic trading venues
entered the market for corporate and municipal bonds over the last 2
years, and several more are preparing to launch this year.\15\ While
there is no guarantee of success for these entrants, markets will
continue to evolve. Thus, it is too early to judge the ultimate impact
of factors affecting fixed-income liquidity.
---------------------------------------------------------------------------
\15\ See SIFMA Electronic Bond Trading Report: U.S. Corporate and
Municipal Securities, Securities Industry and Financial Markets
Association (SIFMA), February 17, 2016, www.sifma.org/issues/
item.aspx?id=8589958906.
---------------------------------------------------------------------------
One thing that will help in this judgment is better data. At the
2015 conference, many market participants expressed a desire for more
publicly available data on Treasury markets. It is striking that so
little data is available--even to regulators--on trading in our
Nation's Treasury market. It took considerable effort to gather
detailed trade data for just the single day of October 15, 2014, in
writing the Joint Staff Report. The Board has been supportive of the
Treasury Department's current Request for Information (RFI), which will
be concluding on April 22. The RFI will provide information on this
issue, as we reassess the adequacy of public information and of the
data available to the official sector for its own monitoring of these
markets.
Thank you. I would be pleased to answer any questions you may have.
______
PREPARED STATEMENT OF ANTONIO WEISS
Counselor to the Secretary, Department of the Treasury
April 14, 2016
Chairmen Crapo and Heller, Ranking Members Warner and Warren, and
Members of both Subcommittees:
Thank you for inviting me to testify today on behalf of Treasury
and alongside Governor Powell from the Federal Reserve Board (Fed). We
have been partners with the Fed, and Governor Powell in particular, on
several topics related to today's hearing. Thank you to both Committees
for choosing to hold a hearing on fixed-income markets, which are at
the heart of our financial system and are undergoing substantial
change.
The primary markets for fixed income are functioning exceptionally
well in the United States. Indeed, the past 4 years have seen record
issuance of corporate bonds, as both domestic and foreign companies
continue to rely on U.S. markets to raise capital.
By most traditional measures, U.S. secondary markets are also
functioning well. There is no compelling evidence of a broad
deterioration in liquidity. But financial markets, fixed-income markets
in particular, are undergoing structural changes, driven by technology,
changing risk appetites and business models, much-needed financial
reform, and changes in the investor base.
Moreover, these developments are occurring against a cyclical
backdrop in which the United States is transitioning toward
normalization from nearly a decade of
unprecedented monetary policy, a transition long expected to be
accompanied by
volatility.
Policy makers are focused on enhancing financial stability and
maintaining well-functioning markets through periods of stress. In this
regard, reforms adopted in
response to the crisis have demonstrably strengthened the core of the
financial system. Markets have experienced several bouts of turbulence
over the past few years--from the ``taper tantrum'' to European
sovereign debt crises to the volatility last August and earlier this
year. In each case, U.S. financial institutions have demonstrated
resilience, instilling confidence in the broader system. This is no
accident. Financial reform has built stronger, more stable
institutions. And the stress tests every large bank undergoes annually
are far more severe than anything experienced since the crisis.
Financial reform has created a buffer for volatile times.
But the tests will surely become more difficult, and we cannot
afford to become complacent. At Treasury, our focus is on understanding
the transitions that are
underway, and anticipating the demands of the new environment. Treasury
is working with the other agencies with authorities in Treasury markets
to undertake the most comprehensive review of the Treasury market since
1998. And U.S. market regulators continue to address potential
operational risks associated with technological changes in their
respective markets.
Record Issuance in Fixed-Income Primary Markets
Fixed income markets play a central role in the U.S. economy,
channeling savings into investment and providing credit to households,
governments, and businesses. Well-functioning markets facilitate
critical financing to Federal, State, and local governments, to
households for mortgage and automobile loans, and to businesses for
investments, job creation, and innovation.
Capital markets play a larger role in the U.S. economy than in
other large, developed economies. Roughly two-thirds of credit is
provided by capital markets in the United States, and one-third through
bank lending, compared to a roughly 50/50 split in the European Union
(EU). The EU, in fact, is taking steps to develop a ``capital markets
union'' to foster more dynamic markets and reduce reliance on bank
funding, which proved costly in the crisis and has likely contributed
to Europe's slower pace of recovery relative to the United States.
Primary markets for fixed income in the United States have
performed exceptionally well for the past several years. Issuance has
been strong--indeed, corporate bond issuance reached record levels over
the past 4 years. Companies have taken advantage of low interest rates
and strong investor demand to issue $7.8 trillion in bonds since the
beginning of 2010. This funding is being used for investments in
plants, equipment, software, research and development, and new workers,
to return money to shareholders, or to build cash buffers to provide
financial flexibility. Issuance has not been limited to U.S.
companies--foreign corporations raised over a trillion dollars in debt
in the U.S. market in the same period.
The market for private residential mortgage-backed securities has
yet to recover. Investor confidence was badly damaged during the crisis
and economic incentives for banks to securitize their non-agency
mortgages remain weak. But the market for residential mortgage
securities backed by Fannie Mae and Freddie Mac has remained strong,
and mortgage rates remain near record lows, supporting the ongoing
recovery in the U.S. housing market.
The Administration remains focused on expanding access to credit
for creditworthy individuals and businesses who remain underserved. But
for borrowers with access to the capital markets, the past several
years have been a time of plenty.
Secondary Market Liquidity
For the most part, U.S. secondary markets are also functioning
well, demonstrating resilience through recent periods of volatility
that were driven by an
uncertain global economic outlook.
Despite repeated claims to the contrary, there is no compelling
evidence of a broad-based deterioration in liquidity. In fact, most
traditional measures of liquidity across U.S. fixed-income sectors are
well within historical levels.
There is no standard definition of liquidity that encompasses all
the variables that matter across products and investor categories. In
the broadest sense, market liquidity refers to the ease with which
buyers and sellers can meet in the marketplace and transact. Market
participants point to a number of measures as proxies for liquidity,
including bid-ask spreads, trading volume, market depth, and the price
impact of trades. Each of these measures captures some aspect of
liquidity, but none is comprehensive. Which measure of liquidity
matters also depends on which element of liquidity you prioritize. For
certain professional investors who trade frequently, low transaction
costs and minimal impact on price may be important. For long-term
investors, keeping costs down over time may matter more than short-term
transaction costs. For large investors such as pensions or retirement
funds, the ability to execute a large transaction may be most
important. And these priorities will shift in response to changing
market conditions.
In the Treasury market, bid-ask spreads and measures of the price
impact of trades in the market for the most-recently issued Treasury
securities are all well within historical ranges (Charts A and B).
Market participants often cite as evidence of worsening liquidity
conditions smaller trade sizes or recent declines in measures of
depth--i.e., the amount available to be purchased or sold at the top
levels in the order book. However, smaller trade sizes are consistent
with the increasing predominance of electronic and algorithmic trading
in the Treasury market. And while depth appears to have declined from
recent high levels, it is well within historical ranges. The elevated
levels from late 2011 into 2013 may have been due to investor
conviction regarding a stable outlook for interest rates (Charts C and
D).
There have, however, been isolated episodes in recent years of
brief spikes in volatility, associated with deteriorating liquidity
conditions during those spikes. The most extreme example was the
October 15, 2014 ``flash rally'' in Treasuries, when the yield on 10-
year notes experienced a 37-basis point roundtrip over a span of
roughly 12 minutes. This episode raises the possibility that improved
day-to-day liquidity, as measured by bid-ask spreads and price impact,
may have come at the cost of rare but severe bouts of volatility and
strains in liquidity.
If these episodes remain rare and fleeting, like October 15, the
ultimate impact on the Treasury market will likely be minimal. But if
the disruptions become more frequent, the effect could be more
significant. We have seen similar episodes in U.S. equities, such as
the May 2010 ``flash crash,'' and foreign exchange markets--two other
markets with significant levels of algorithmic trading. But we must be
especially watchful when it comes to the world's risk-free benchmark,
and this is why we initiated the first comprehensive review of the
Treasury market since 1998.
Market participants also report challenges in the market for aged,
or ``off-the-run,'' Treasuries. The price differences between on- and
off-the-run Treasuries do not indicate a great disparity in liquidity
conditions (Chart E), but due to data limitations we do not have as
granular a view into off-the-run markets. As discussed further below,
we are working to address these data limitations.
In U.S. corporate bond markets, measures of transaction costs are
also well within historical ranges, and perhaps even healthier than in
the early 2000s (Chart F). Some have pointed to a decline in dealer
inventories of corporate bonds since 2006 and 2007 as a harbinger of
declining liquidity, because dealers would be less likely to act as
``shock absorbers.'' But analysis by Goldman Sachs and others shows
that pre-crisis inventory levels were inflated by holdings of mortgage-
backed securities and esoteric structured products that are no longer
used. Actual corporate inventories have declined, but were not large in
relation to the overall market to begin with. Moreover, the
relationship between inventories and liquidity is far from clear.
Research from the Federal Reserve Bank of New York shows that dealer
positions tend to be procyclical (Chart G). In other words, rather than
acting as shock absorbers, dealers have historically reduced their
positions during periods of stress.
Overall, corporate bond trading volumes have increased (Chart H), a
sign that there has been no broad withdrawal from the U.S. market.
Average trade sizes have begun to decline, as well as the proportion of
large ``block'' trades (Charts I and J). These data points are
consistent with trends toward greater electronification and more
``agency-based'' intermediation, which are discussed below. As Fed
Governor Lael Brainard recently pointed out, these data points are also
consistent with reports by market participants of the need to break up
large trades into smaller trades over time.
Financial Reform Strengthened the Core of the Financial System
Market liquidity is an important element in a well-functioning
financial system. As we learned so painfully in the crisis, and less
dramatically in many other instances, when secondary markets cease to
function effectively, firms and households can lose access to the
primary markets, cutting off their access to financing for investments,
hiring, and home purchases.
But liquidity is also a function of market dynamics, and varies
across markets and over cycles. Prior to the crisis, liquidity was
abundant by almost any measure. However, this liquidity was a result of
soaring financial sector leverage, an over-reliance on short-term
funding, and financial activity driven by a proliferation of structured
and synthetic vehicles, often held off-balance sheet. Some investment
banks were leveraged 40- or 50-to-1, while short-term wholesale funding
had grown to over 30 percent of the largest banks' and investment
banks' total assets. That apparent liquidity not only disappeared when
it was needed most, but led to forced selling that greatly exacerbated
financial distress.
Policy makers have taken significant steps following the crisis to
strengthen the core of the financial system, to reduce the
vulnerability of markets to those kinds of fire sale dynamics. In
particular, financial reform has created more resilient financial
intermediaries, more stable funding profiles, and sounder market
structures. These steps have contributed to more resilient financial
markets that are better prepared to continue to support the economy
through periods of stress.
A major pillar of post-crisis reform has been to create more
resilient financial institutions, most fundamentally by increasing
capital requirements. Stronger market intermediaries are better able to
absorb risks under stressed conditions, and reduce the risk of market
disruptions. Policy reforms and changes in market practices following
the crisis have also led to significant declines in leverage, as the
largest banks have more than doubled their capital levels since 2009.
A second pillar of reform is more resilient funding structures. The
largest financial institutions have more than doubled their holdings of
high-quality liquid assets, increased their deposit base, and reduced
their reliance on short-term funding by nearly half. Off-balance sheet
funding vehicles have all but disappeared.
A third pillar in these efforts is building more fundamentally
sound market structures. Financial reform required certain standardized
derivatives to be centrally cleared and traded on transparent
platforms, and all derivatives contracts to be reported to swap data
repositories. According to CFTC Chairman Massad, 75 percent of interest
rate swaps are now centrally cleared, compared to 15 percent in 2007.
These reforms are enhancing resilience and transparency in one of the
largest markets in the world, a market closely linked to other fixed-
income markets.
In the remainder of my testimony I will describe the changes
underway in U.S. fixed-income market structure, and the efforts by
Treasury and other policymakers and market participants to respond to
these changes.
Changes in Fixed-Income Market Structure
The structure of fixed-income markets is undergoing significant
transition. This transition is driven by advances in technology,
changes in business models and risk appetite, and much-needed
regulatory reforms adopted in response to the crisis. Many of these
changes are also contributing to a change in the way intermediaries
match buyers and sellers in these markets. Shifts in the composition of
asset owners are also playing an important role.
In a trend that pre-dates the crisis, technology is enabling the
spread of electronic trading across fixed-income markets. In markets
for standardized, benchmark securities, algorithmic trading has become
predominant. This transition began in the 1990s in equities, and then
spread to futures and foreign exchange markets. Beginning just over a
decade ago, the inter-dealer market for the most recently issued
Treasury securities-so-called ``on-the-run'' securities-began to
transition toward algorithmic trading. Partly as a result of technology
upgrades in recent years, algorithmic trading by principal trading
firms (PTFs) now accounts for over half of trading volume in this
market on most days, and up to 70 percent of volume during volatile
trading.
In markets for securities with a greater degree of customization,
like corporate bonds, algorithmic trading has not taken root, but more
basic electronification has begun. In some cases, the old ways of doing
business over the telephone--that is, customers requesting dealers to
provide quotes--have simply migrated to the computer screen. There is
also a small, but growing, portion of corporate bond trading happening
on ``all-to-all'' venues--that is, trading directly between end
investors without a dealer between them.
There is also a transition underway in how intermediaries match
buyers and sellers. Fixed-income securities markets have historically
been a predominantly ``principal-based'' market. Intermediaries bought
securities from investors looking to sell, and held them on their own
balance sheet until a buyer could be found. The majority of fixed-
income securities markets remain principal-based, with dealers
accounting for well over half of all volume in both Treasury and
corporate bond markets. But ``agency'' intermediation, where
intermediaries match buyers and sellers for a commission, is
increasingly prevalent in fixed-income markets, especially markets for
standardized, benchmark securities.
Changes in business models, competition from new entrants, and
much-needed regulatory reforms adopted in response to the crisis have
likely contributed to the shifts described above. Large banks and
broker-dealers have significantly reduced their leverage, reined in
their risk appetites, and sought more resilient sources of funding.
Meanwhile, new entrants such as PTFs, previously active mostly in
equities and futures markets, are increasingly competing with
traditional dealers for market share in standardized products such as
on-the-run Treasuries.
The composition of buyers and sellers is also changing. The growth
of open-end mutual funds investing in corporate bonds has received
significant attention--mutual funds now own over 20 percent, or over $2
trillion, of U.S. corporate bonds. There is concern that funds offering
daily liquidity to investors but investing in less liquid assets may be
forced sellers in a stressed environment, or may contribute to
spillovers by selling more liquid assets to meet redemptions.
At the same time, large investors like pension funds, sovereign
wealth funds, and insurance companies have continued to grow. These
investors typically buy and hold large portfolios of bonds, as they
seek to match their long-term liabilities with fixed-income returns. In
total, there are over $30 trillion of fixed-income securities held by
this diverse set of buyers, with differing investment objectives. These
investors may ultimately be the buyers of last resort during periods of
turbulence. Indeed, research shows that was likely the case during the
2013 ``taper tantrum.'' These shifts are all taking place against a
backdrop in which the United States is transitioning to a path of
normalization from nearly a decade of unprecedented monetary policy.
Market participants have always expected this period of adjustment
would be accompanied by turbulence as expectations for economic and
financial conditions adjust. Indeed, volatility in Treasuries has
typically preceded other recent rate hiking cycles.
In this regard, it is important to distinguish between re-pricing
events, driven by fundamental factors, and breakdowns in market
functioning that may be exacerbated by poor liquidity. As PIMCO noted
in a recent op-ed, ``[a]brupt changes in valuations are not necessarily
liquidity events.''
All of these shifts are changing the way buyers and sellers meet
and transact in fixed-income markets. The end-state for fixed-income
trading remains far from certain, but it is important to understand
that economic and financial cycles, advances in technology, financial
product innovations, and policy all play a role.
Policy Priorities to Build More Resilient Market Structures
At Treasury, we are engaged in several efforts to understand and
respond to the changes underway in financial markets, and safeguard the
resilience of the U.S.
financial system. Most importantly, we are focused on completing and
safeguarding financial reform. Nothing would do more to undermine the
resilience of our markets than rolling back Wall Street Reform. The
Administration is working with regulators to implement all remaining
material elements of Dodd-Frank by the end of the year.
Internationally, Treasury is working to ensure other countries follow
through on their commitments as well, to reduce risks that may emanate
from abroad.
We are also working to address potential vulnerabilities in
financial market structure. Most notably, Treasury is engaged, together
with the Fed, Federal Reserve Bank of New York, CFTC and SEC, in the
most comprehensive review of the Treasury market since 1998. As part of
this review, in January Treasury issued a Request for Information (RFI)
on the evolution of Treasury market structure seeking feedback on a
series of detailed questions across four areas:
The evolution of the Treasury market;
Risk management practices and market conduct across the
Treasury market;
The types of data that should be made available to the
official sector regarding Treasury cash market activity, and
numerous practical considerations associated with gathering
that data; and
Potential additional reporting of Treasury market
transactions to the public. The comment deadline is April 22,
and we look forward to reviewing all responses, and would be
happy to report back to these Subcommittees with key findings.
At this point, the most immediate conclusion from our work is that
the official sector needs access to more data, on a more timely basis,
with more effective data sharing mechanisms. The RFI seeks comment on
the most effective and efficient way to achieve these objectives, and
by the end of the year we expect to have in place a comprehensive plan
for reporting of transactions in the Treasury cash market to the
official sector.
Separately, the Financial Stability Oversight Council, or FSOC, is
closely examining potential vulnerabilities related to changes in
market structure, which it highlighted in its most recent annual
report. FSOC is analyzing potential risks along three dimensions, which
dovetail with the themes identified in the Joint Staff Report on
October 15th:
First, risks related to operational resiliency and
preparedness arising from the increase in electronification
across several markets;
Second, the need to coordinate, to the extent possible,
prudential and supervisory standards across different venues
for products that share similar risk characteristics; and
Third, to look at ways to improve data collection and
sharing in certain
markets.
FSOC is also analyzing risks associated with asset management
activities, including potential risks arising from mutual funds
offering daily liquidity to investors while investing in less liquid
underlying assets, particularly fixed-income assets. Policy makers and
market participants have increased their focus on these potential risks
as the proportion of corporate bonds owned by mutual funds has more
than doubled over the past several years.
A recent example of the potential risks associated with that
liquidity mismatch occurred in December, when the Third Avenue Focused
Credit Fund suspended redemptions because it could not sell assets
quickly enough to meet large redemption requests. Third Avenue's
actions came in the midst of overall stress in the broader high-yield
market, contributing to pressure that led investors to pull nearly $10
billion--four percent of assets under management--from high-yield funds
during a 3-week period in December.
FSOC is analyzing these and other risks related to asset management
products and activities, and will be providing an update on its work
this spring. The SEC has pending proposals in this area, and additional
proposals are expected, including standards for stress testing by asset
managers.
Finally, I should note the efforts by market regulators, the CFTC
and SEC, to
address risks related to evolving technology and market structures in
their respective markets. Most recently, the CFTC proposed Reg AT to
impose risk controls, transparency measures, and other safeguards to
enhance the regulatory regime for
algorithmic trading in futures. In addition, the SEC proposed rules
related to alternative trading platforms in the equities market, and
asked a series of questions
related to the operation and regulation of similar platforms in fixed-
income markets. Treasury will continue to engage with both regulators
in areas of common interest.
Conclusion
In the years since the crisis, primary market issuance has been
robust, helping to support the economic recovery in the United States.
But the structure of fixed-income markets is undergoing a period of
major transition, and the nature of liquidity provision in these
markets is changing in parallel. Technology, changing risk appetites
and business models, and policy changes are all contributing. One would
expect the public and private sectors to make significant changes
following the second largest financial crisis in 100 years.
The past 9 months have seen a period of heightened volatility in
financial markets, and the U.S. financial system demonstrated
resilience. Financial reform has strengthened the core of our financial
system, increasing confidence in volatile times. But inevitably the
tests will become more difficult, and neither market participants nor
policymakers can afford to become complacent.
In fixed-income markets, it's clear we haven't reached an end
state. At Treasury, we are in the midst of the first comprehensive
review of the Treasury market in nearly two decades, and working with
regulators to collect and share information more effectively. We are
also working with FSOC member agencies to identify and address
potential risks to financial stability arising from changing market
structures and shifts in the composition of market participants.
Internationally, we are working with our counterparts to analyze and
monitor market liquidity trends in overseas markets. There is much left
to do. But the progress made since the crisis is real, and the
financial system is more resilient as a result. These efforts
ultimately provide the foundation for deep, liquid, and resilient
capital markets, and will provide ballast when the next period of
market turbulence strikes.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
RESPONSE TO WRITTEN QUESTION OF CHAIRMAN CRAPO FROM JEROME H.
POWELL
Q.1. It has been brought to my attention that Federal Reserve
examiners are seeking access to board meetings of companies in
the normal course of business and that this is a new practice.
Could you please tell me what guidance or process the Board of
Governors provides to regional examiners as to their
interaction with the boards of the bank and whether regional
banks have a uniform practice for their examiners with respect
to this practice?
A.1. As you are aware, the Board is authorized by statute to
examine and obtain information from State member banks and
bank-holding companies to ensure that the companies are
operated in a safe and sound manner. 12 U.S.C. 248(a), 1844.
Board supervisory staff meet with boards of directors or board
members of regulated institutions to allow for the exchange of
information and presentation of supervisors' examination
findings to the institutions' boards of directors.
The Federal Reserve has a long-standing practice whereby
supervisors attend an annual board meeting of a financial
institution to present the Federal Reserve's annual supervisory
assessment to the board of directors. This presentation is
often coordinated with presentations by the Federal Deposit
Insurance Corporation or the Office of the Comptroller of the
Currency on their assessment of the underlying insured
depository institution.
This is part of the normal interactive supervisory process,
and often serves as an opportunity to ensure that the entire
board of a banking organization is aware of supervisory
concerns. In some cases, supervisors ask to meet separately
with the independent board members (those who do not have other
roles in the banking organization) in order to ensure that
those directors have access to all relevant information
relating to risk management and other supervisory concerns.
Supervisors also meet periodically with the individual board
members to discuss the firm's strategic plans and current areas
of supervisory focus, often on the firm's initiative.
The Board views banking organization boards of directors as
key players in ensuring the safety and soundness of banking
organizations. Congress emphasized the importance of
involvement by boards of directors in risk management by
requiring, through the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank Act), that the Board of
Governors adopt regulations requiring each bank-holding company
with assets over $50 billion and each firm designated for Board
supervision by the Financial Stability Oversight Counsel (FSOC)
to establish a risk committee of the board of directors.\1\ The
Dodd-Frank Act requires the risk committee to be responsible
for oversight of the enterprise-wide risk management practices
of the firm and to include both independent directors and at
least one member with risk management experience at large,
complex firms.
---------------------------------------------------------------------------
\1\ Dodd-Frank Act 165(h).
---------------------------------------------------------------------------
Meetings by supervisory staff with members of the board of
directors are thus part of the cooperative, iterative
communications between a supervised banking organization and
its regulator and allow board members to directly gain access
to supervisory
insights.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SASSE FROM JEROME H.
POWELL
Q.1. Mr. Weiss argued in this hearing that liquidity measures
during the run-up to the 2008 financial crisis serve as an
inappropriate ``liquidity benchmark'' because this liquidity
was illusory, and more ``a result of soaring financial sector
leverage and an over-reliance on short-term funding.'' If,
arguendo, this is true, what historical era should serve as an
appropriate benchmark?
A.1. The degree of liquidity in a given market will change over
time as economic circumstances and market structures change.
Thus, it is not clear that there is an obvious benchmark period
that one could easily refer to in order to determine whether
current market liquidity is either too low or too high. The
Trade Reporting and Compliance Engine or ``TRACE'' began
collecting data on corporate bond trading in 2002 and
widespread electronic trading in the interdealer Treasury
market began at roughly the same time. As noted by Mr. Weiss,
this period is the run-up to the financial crisis. It is not
clear that that period, or the current post-crisis period
represent a proper benchmark.
Rather than compare current conditions to a benchmark
period, it may be more appropriate to ask whether the pricing
of liquidity services accurately reflects all the costs and
risks of providing those services. As Mr. Weiss noted, there
are good reasons to believe that this was not the case prior to
the financial crisis, as it became clear during the crisis that
many participants had relied on unrealistic assumptions about
the stability of market volatility and funding sources in
making their investment decisions. Currently, financial sector
leverage and short-term funding stand at much more appropriate
levels and banks have reassessed their own risk appetites to
perhaps better reflect business risks, which all should lead to
more pricing of market liquidity that more accurately reflects
the risks involved. An assessment of market liquidity also
needs to analyze whether the level of liquidity is an
impediment to economic growth. This is always difficult to
measure, but with robust demand for corporate and Treasury
debt, there are no signs that liquidity conditions are
currently inhibiting either private or Government funding or
the economic recovery.
Q.2. Governor Powell testified in this hearing that ``[i]t may
be that liquidity has [currently] deteriorated only in certain
market segments.'' Please describe which market segments are
most likely to have experienced liquidity deterioration and
why.
A.2. As discussed in my the testimony, it is important first to
note that observable measures of overall liquidity in fixed-
income
markets do not point to any deterioration. Measured bid-ask
spreads in the interdealer market for on-the-run Treasury bonds
have been stable in recent years, while estimated price impacts
of trading are at levels comparable to those in 2005.\1\
Observable measures such as the spread between on- and off-the-
run Treasury securities do not show any trend change in
liquidity between the two market segments since the financial
crisis. In corporate bond markets, estimated bid-ask spreads
have declined and estimated price impacts are lower than in the
early 2000s, indicating that, if anything, liquidity may have
improved.\2\
---------------------------------------------------------------------------
\1\ See Tobias Adrian, Michael Fleming, Daniel Stackman, and Erik
Vogt, Has U.S. Treasury Market Liquidity Deteriorated?, Liberty Street
Economics (blog), August 17, 2015.
\2\ See Bruce Mizrach, ``Analysis of Corporate Bond Liquidity,''
Financial Industry Regulatory Authority (FINRA), Office of the Chief
Economist Research Note, December 2015.
---------------------------------------------------------------------------
However, at the same time, we must recognize that our
ability to measure market liquidity is imperfect. We have less
data on dealer-to-customer trading in Treasury markets than in
the interdealer market, and, given the nature of the corporate
bond market, estimates of liquidity are based on transactions
rather than on direct observations of quotes to buy or sell
these bonds. Changes in market structure have also meant that
participants now must break up their larger trades and employ
complicated strategies in order to avoid moving prices.
Accurately measuring the effect of trading on prices, perhaps
the most fundamental gauge of market liquidity, can be quite
difficult in such an environment.
With this in mind, it is difficult to identify specific
market segments in which liquidity may have deteriorated with a
great degree of confidence. As the testimony noted, there is
some evidence that liquidity has deteriorated for the lowest-
rated corporate bonds. Although work by staff at the Federal
Reserve Bank of New York have found that estimated price
impacts of trading have declined across all issue sizes in this
market, they also find some weak evidence that price impacts
may have increased for bonds rated CC or lower.\3\ This
evidence is suggestive, but far from conclusive. Some industry
participants have also pointed to a bifurcation in corporate
bond markets, with smaller, less-traded bonds suffering from a
deterioration in liquidity. We have not found evidence that
supports these claims but are continuing to investigate this
issue and trends in market liquidity more generally.
---------------------------------------------------------------------------
\3\ See Tobias Adrian, Michael Fleming, Erik Vogt, and Zachary
Wojtowicz, Further Analysis of Corporate Bond Market Liquidity, Liberty
Street Economics (blog), February 10, 2016.
---------------------------------------------------------------------------
To the extent that liquidity has deteriorated in some less
liquid corporate bond segments, there could be several
explanations. As my testimony noted, these segments may rely
heavily on intermediation by dealers, and dealers have scaled
back their capital commitments and inventories in corporate
bonds since the financial
crisis.\4\ Investors, particularly mutual funds and other asset
managers that now comprise a larger share of the market, may
also prefer to concentrate trading in more liquid segments. To
the
extent this was the case, it would lead to decline in liquidity
in less frequently traded segments of the market.
---------------------------------------------------------------------------
\4\ See Hendrik Bessembinder, Stacey E. Jacobsen, William F.
Maxwell, and Kumar Venkataraman, Capital Commitment and llliquidity in
Corporate Bonds, Social Science Research Network (SSRN), March 21,
2016.
Q.3. Please provide a list of upcoming new rules or regulations
either from your agency, or others that you are aware of, that
may have a material impact on liquidity in the fixed-income
---------------------------------------------------------------------------
markets.
A.3. It is not easy to predict ahead of time which rules either
may affect fixed-income market liquidity or may be perceived to
affect fixed-income market liquidity in light of the inherent
uncertainties in measuring market liquidity. At the same time,
some market participants have claimed that the Net Stable
Funding Ratio rule recently proposed by the U.S. banking
agencies may have an impact on fixed-income market liquidity.
The U.S. banking agencies assessed the potential impact of the
proposed rule and expect the benefits to outweigh the costs.
The agencies have asked for public comment on the impact of the
proposed rule on firms and on the broader economy, and staff
will be analyzing comments and impact data carefully as we move
forward. The Board takes steps to help ensure that each of its
financial regulations achieves its intended outcome at least
cost to market liquidity and other beneficial aspects of
economic activity.
Q.4. Governor Powell said that ``some reduction in market
liquidity is a cost worth paying in helping to make the overall
financial system significantly safer.'' Is there also a risk
that reducing liquidity in the marketplace also makes the
marketplace unsafe? If so, how should regulators discern the
difference between an unsafe reduction in liquidity and a safe
reduction in liquidity?
A.4. A central insight that was revealed during the financial
crisis is that liquidity provision is a risk-bearing activity
that can result in significant losses during a period of
financial stress. Post-crisis regulatory reform efforts have
focused in ensuring that the risks if liquidity provision are
appropriately accounted for in the context of capital and
liquidity regulation. Regulation that penalizes liquidity
provision by ascribing to it a degree of risk that is not
commensurate with the actual risks incurred could lead to an
unnecessary
reduction in liquidity provision that would not be warranted by
market fundamentals such as supply-demand dynamics.
Accordingly, the Federal Reserve is committed to assessing the
impact of post-crisis reform legislation on an ongoing basis to
assess whether
enhanced capital and liquidity regulations treat liquidity
provision in a manner consistent with the risks incurred by the
provision of such services.
Q.5. Governor Powell testified at this hearing that ``there is
some evidence [that] liquidity in lower rated bonds has
deteriorated.'' What are potential negative economic effects of
this deterioration, including for newer companies, and smaller-
to medium-sized firms?
A.5. As noted in the response to question 2, it is difficult to
identify specific market segments in which liquidity may have
deteriorated with a great degree of confidence, however, my
testimony did note that there is some evidence that liquidity
has deteriorated for the lowest-rated corporate bonds. Although
work by staff at the Federal Reserve Bank of New York has found
that estimated price
impacts of trading have declined across all issue sizes in this
market, they also find some weak evidence that price impacts
may have increased for bonds rated CC or lower.\5\
---------------------------------------------------------------------------
\5\ See Tobias Adrian, Michael Fleming, Erik Vogt, and Zachary
Wojtowicz, Further Analysis of Corporate Bond Market Liquidity, Liberty
Street Economics (blog), February 10, 2016.
---------------------------------------------------------------------------
This evidence is suggestive, but far from conclusive, that
if liquidity has indeed declined in these market segments,
there could eventually be a negative impact on primary issuance
for lower rated firms if the decline was large enough. However,
we do not see evidence of this. Corporate bond issuance has
been strong over the post-crisis period, both in the investment
grade and high-yield segments. While there was some decline in
issuance in the second half of 2015 and the first months of
2016, issuance declined only moderately from very high levels.
This decline appears to have been linked more to a pull-back in
risk sentiment over this period rather than to any decline in
market liquidity. More recently, issuance has shown signs of
picking back up as risk sentiment has improved.
Q.6. Governor Powell testified at this hearing that ``questions
about whether liquidity and fixed-income markets has broadly
deteriorated are very difficult to answer definitively.''
Governor Powell also testified that ``these regulations [that
have been imposed since the 2008 financial crisis] are new and
we should be willing to adjust them as we learn.''
a. LWhat process is in place or should be in place at the
financial regulatory agencies to understand the impact
of these new rules and regulations on liquidity?
b. LGiven the importance of liquidity in the marketplace and
the admitted uncertainty surrounding this issue, is
there merit to considering delaying the imposition of
new financial rules and regulations, to facilitate a
broader examination of the cumulative impact of these
new rules and regulations on liquidity in the
marketplace?
A.6. The Federal Reserve is committed to analyzing liquidity
conditions across a wide array of financial markets as market
liquidity is important for the conduct of monetary policy, the
health of the financial system and financial stability. Federal
Reserve staff regularly assess and monitor liquidity conditions
on an ongoing basis for all of the reasons previously cited.
Moreover, the Federal Reserve in conjunction with the Federal
Deposit Insurance Corporation, Office of the Comptroller of the
Currency, Securities and
Exchange Commission and Commodity Futures Trading Commission
regularly submit a report on fixed-income market liquidity to
the House Financial Services Committee as a result of Chairman
Jeb Hensarling's request to regularly monitor fixed-income
market liquidity and any potential effects that the Volcker
rule may have on market liquidity. It is expected that these
efforts will continue and that new efforts to understand the
state of market liquidity and the effect of financial
regulation on market liquidity will continue to evolve over
time as the regulations mature and any effects become easier to
measure overtime.
While the effects of financial regulation on market
liquidity are uncertain, there is less uncertainty around the
idea that post-crisis reform measures are needed to address
significant shortcomings in the regulatory regime that were
revealed during the financial crisis. Accordingly, halting
financial reform risks continued exposure to shortcomings that
are relatively well-documented and understood, while any
benefits on market liquidity are uncertain. This is not to say,
however, that market liquidity should not be an important
consideration in the design and implementation of financial
regulation. Rather, in the designing of financial regulation,
steps should be taken to ensure that regulation does not unduly
suppress market liquidity or other beneficial aspects of
economic activity. As these regulations are implemented,
regulators should assess whether regulations should be modified
to better manage any identified tradeoff between the principal
goals of regulation, that is, enhanced capital or liquidity,
and market liquidity.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR TOOMEY FROM ANTONIO
WEISS
Q.1. You argued before the Committee that pre-crisis levels are
a ``poor benchmark for liquidity.'' But, if you examine the
post-crisis period, there is a consistent decrease in
liquidity. As an example, dealer balance sheets of corporate
credit and securitized products have declined approximately 30
percent. Some analysts expect it to decline further by another
5 percent to 15 percent. Spreads in many fixed-income products
have widened and turnover has declined, which is further
evidence of a less liquid market.
LDo you still maintain that liquidity has not
declined during the post-crisis period?
LIf so, could you please indicate those data points
you find relevant to tracking liquidity levels which
indicate no change in the post-crisis period?
A.1. Despite repeated claims to the contrary, there is no
compelling evidence of a broad-based deterioration in
liquidity. Market participants point to a number of measures as
proxies for liquidity, including bid-ask spreads, trading
volume, market depth, and the price impact of trades. Most of
these traditional measures of liquidity across U.S. fixed-
income sectors are well within historical levels.
Bid-ask spreads for U.S. Treasury securities have remained
tight, and spreads for corporate bonds are consistent with or
below recent historical levels. Turnover has declined in some
markets, but is not a good proxy for liquidity. For example,
turnover may increase during periods of high volatility, such
as October 15, 2014, a day with especially high turnover. In
corporate bonds, volumes have increased, but the strength in
issuance, especially among many new issuers whose bonds don't
trade frequently, has resulted in lower turnover. Finally,
while some have cited the decline in dealer inventories, this
is a poor measure of liquidity. Inventories represent a very
small percent of the total corporate credit market, even prior
to the crisis, and despite claims that inventories serve as a
shock absorber, historically dealers have decreased their
positions during periods of stress and potentially contributed
to sell-offs.
Q.2. I have read research that suggests, in light of the record
corporate debt issuance of late, that the need for liquidity
has never been greater but we are in an environment when there
is diminished capacity to provide that liquidity due to a
widespread reduction of dealer market making.
LIs it possible that some of these problems are
being masked at the moment by exceptionally
accommodative monetary policy and a reach for yield by
many investors?
LIf the Fed were to actually move forward on a
defined path of policy normalization, whereby interest
rates would substantially rise, do you believe that
there is sufficient liquidity to maintain orderly
markets?
A.2. Fixed-income markets have been influenced by a number of
both secular and cyclical factors, including electronification,
a changing mix of participants, record-breaking issuance,
changing dealer business models, economic cycles, and monetary
policy. Emerging from a period of historically low interest
rates and low volatility could result in an increase in
volatility, consistent with historical experiences. Price
movements, even significant ones, in response to changes in
economic and policy outlooks are not necessarily a result of
illiquidity. For example, the so called ``taper tantrum'' in
2013, in which long-term interest rates increased over 100
basis points, saw significant price movements but no obvious
breakdown in market functioning. Treasury is focused on
understanding the transitions that are underway and
anticipating the contours of the new environment.
Q.3. It appears that there remains a strong difference of
opinion on whether liquidity impairment is an unintended
consequence of recent financial regulations. Given the state of
the debate, it seems as though data points being used to argue
both sides of the argument are worthy of further investigation.
Other jurisdictions, like the European Union, are establishing
formal review mechanisms designed to evaluate the impact of
financial regulatory measures on markets and the broader
economy.
LWould you be willing to conduct a formal and
holistic review of the impact financial regulation is
having on U.S. capital markets, analogous to that being
performed under the EU's ``call for evidence?''
A.3. Reforms adopted following the financial crisis have
created a stronger, more resilient financial system. However,
neither market participants nor policymakers can afford to
become complacent. Treasury continues its work analyzing
developments in financial markets and market structures,
including those related to policy developments. For example,
Treasury is engaged in the official sector's most comprehensive
review of the Treasury market since 1998. In 2015, Treasury,
together with the Federal Reserve Board, the Federal Reserve
Bank of New York, the CFTC and the SEC, issued the Joint Staff
Report on the events of October 15, 2014. Earlier this year,
Treasury issued a request for information on the evolution of
Treasury market structure and has recently reviewed the public
comments received. We are also working with FSOC-member
agencies to identify and address potential risks to
financial stability arising from changing market structures and
shifts in the composition of market participants. The FSOC also
recently released a study on the economic impact of possible
financial services regulatory limitations intended to reduce
risks to financial
stability.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SASSE FROM ANTONIO
WEISS
Q.1. Mr. Weiss argued in this hearing that liquidity measures
during the run up to the 2008 financial crisis serve as an
inappropriate ``liquidity benchmark'' because this liquidity
was illusory, and more ``a result of soaring financial sector
leverage and an over-reliance on short-term funding.'' If,
arguendo, this is true, what historical era should serve as an
appropriate benchmark?
A.1. There is no standard. definition of liquidity that
encompasses all the variables that matter across products and
investor categories. Market participants point to a number of
measures as proxies for liquidity, including bid-ask spreads,
trading volume, market depth, and the price impact of trades,
each of which may be influenced by the changes in market
structure that inevitably occur over time. Similarly, given the
changing nature of market structure and other secular and
cyclical factors, there is no one historical period that can
serve as a perfect benchmark to assess liquidity conditions. We
attempt, where possible, to analyze market developments over a
sufficiently long time period that multiple points in financial
and economic cycles are represented. For example, many of the
charts referenced in my testimony present data as far back as
2005, and in some cases as far back as 2002. In many cases,
however, a lack of available or consistent data constrains the
ability of policymakers and market participants to conduct that
kind of analysis.
Q.2. Governor Powell testified in this hearing that ``[i]t may
be that liquidity has [currently] deteriorated only in certain
market segments.'' Please describe which market segments are
most likely to have experienced liquidity deterioration and
why.
A.2. Despite repeated claims to the contrary, there is no
compelling evidence of a broad-based deterioration in
liquidity. In fact, most traditional measures of liquidity
across U.S. fixed-income sectors are well within historical
levels. Market participants point to a number of measures as
proxies for liquidity, including bid-ask spreads, trading
volume, market depth, and the price impact of trades. Each of
these measures captures some aspect of liquidity, but none is
comprehensive.
Q.3. Please provide a list of upcoming new rules or regulations
either from your agency, or others that you are aware of, that
may have a material impact on liquidity in the fixed-income
markets.
A.3. The only remaining rule which Treasury is responsible for
implementing is the QFC recordkeeping rule.
Q.4. Governor Powell said that ``some reduction in market
liquidity is a cost worth paying in helping to make the overall
financial system significantly safer.'' Is there also a risk
that reducing liquidity in the marketplace also makes the
marketplace unsafe? If so, how should regulators discern the
difference between an unsafe reduction in liquidity and a safe
reduction in liquidity?
A.4. Post-crisis financial reform has made the financial system
safer and more resilient. Financial reform has created more
resilient financial intermediaries, more stable funding
profiles, and sounder market structures, providing the
foundation for deep, liquid, and resilient capital markets.
Q.5. Governor Powell testified at this hearing that ``there is
some evidence [that] liquidity in lower rated bonds has
deteriorated.'' What are potential negative economic effects of
this deterioration, including for newer companies, and smaller-
to medium-sized firms?
A.5. While there have been anecdotal reports of periods during
which liquidity conditions have been challenging, the market
for lower-rated bonds has always been less liquid than many
markets and Treasury's analysis of the available data has not
shown convincing broad-based evidence of deterioration. In
addition, primary markets for fixed-income issuance in the
United States have performed exceptionally well for the past
several years, with corporate bond issuance reaching record
levels over the past 4 years. In particular, while most newer
and smaller- to medium-sized firms have traditionally not
issued bonds, some first time and smaller issuers have been
able to leverage the strong market conditions in recent years
to issue bonds and raise funds for their businesses.
Q.6. Governor Powell testified at this hearing that ``questions
about whether liquidity and fixed-income markets has broadly
deteriorated are very difficult to answer definitively.''
Governor Powell also testified that ``these regulations [that
have been imposed since the 2008 financial crisis] are new and
we should be willing to
adjust them as we learn.''
a. LWhat process are in place or should be in place at the
financial regulatory agencies to understand the impact
of these new rules and regulations on liquidity?
b. LGiven the importance of liquidity in the marketplace and
the admitted uncertainty surrounding this issue, is
there merit to considering delaying the imposition of
new financial rules and regulations, to facilitate a
broader examination of the cumulative impact of these
new rules and regulations on liquidity in the
marketplace?
A.6. Reforms adopted following the financial crisis have
created a stronger, more resilient financial system. At the
same time, our financial markets continue to evolve in response
to a variety of factors and forces. For instance, advancements
in technology, and the associated growth in high-speed
electronic trading, have contributed to changes in
intermediation and the provision of liquidity in many financial
markets. Treasury has been engaged, and will continue to be
engaged, in rigorous, data-driven analysis of financial markets
and market structures, and Treasury staff has published some of
its analysis as blog posts available on the Treasury website.
Treasury's analysis of conditions in the U.S. Treasury market
suggests that liquidity is consistent with historical levels.
More broadly, Treasury is engaged in the official sector's
most comprehensive review of the Treasury market since 1998. In
2015, Treasury, together with the Federal Reserve Board, the
Federal Reserve Bank of New York, the CFTC and the SEC, issued
the Joint Staff Report on the events of October 15, 2014.
Earlier this year, Treasury issued a request for information on
the evolution of Treasury market structure and has recently
reviewed the public comments received. In July, the SEC
published for comment a proposed rule from the Financial
Industry Regulatory Authority that would require its member
brokers and dealers to report Treasury cash market transactions
to a centralized repository, giving the official sector better
access to Treasury market transaction data. In addition,
Treasury, CFTC, SEC, and the Federal Reserve Board signed a
memorandum of understanding that permits sharing of information
on U.S. Treasury cash and related derivative markets among the
agencies, which facilitates analysis across the interest rate
complex. We are also working with FSOC-member agencies to
identify and address potential risks to financial stability
arising from changing market structures and shifts in the
composition of market participants.