Despite the eye-catching title of the discussion – “Is there a liquidity crisis?” – a group of panellists at FIA Expo on Oct. 30 agreed that the industry has witnessed many innovations and market structure changes that have democratised the derivatives markets and introduced new participants over the past 10 years.
However, they also acknowledged that more work needs to be done to address factors that have impacted liquidity, such as regulation and the consolidation of FCMs.
Commissioner Brian Quintenz of the U.S. Commodity Futures Trading Commission underscored the important role regulation plays on liquidity. “Regulations can either promote liquidity or they can penalise liquidity, and how this shakes out is whether or not those regulations are calibrated appropriately to the risks of the activity that they address,” he said.
Quintenz said the CFTC is engaged in “three buckets” of activity that relate to liquidity. The first is revisiting prior implementations of regulation that have had a negative impact on liquidity, including the re-write of the Volcker Rule, adjustments to the supplementary leverage ratio, the move away from CEM (current exposure method) to SA-CCR (standard approach to counterparty credit risk) and the amendment to the de minimis threshold.
The second is amending and finalising proposals that could have a negative impact on liquidity; and the third is taking steps to promote liquidity.
“I would put position limits and our capital rule for swap dealers in the second bucket, where we hope to rewrite proposals so that they’re more respectful of risk,” Quintenz said. “Arguably, they could have had a big impact on liquidity and activity in the marketplace. Both are live issues at the Commission right now, and staff are working diligently on those.”
“In the proactive bucket, where the CFTC can do more to promote liquidity, the first there would be providing more deference and substituted compliance to foreign regimes, especially for trading platform equivalence,” he added. “The second is a new portfolio margining regime that we’re working on with the SEC that will release some capital efficiencies and capital into the real economy from a portfolio marginal basis.”
Some of the panellists had mixed views about the impact of post-crisis reforms on liquidity. Mariam Rafi, managing director, and North American head of OTC clearing at Citi, said reforms overall have been helpful to liquidity provision by providing greater transparency and improving the safety and soundness of products moving to clearing.
Where the industry has seen some deterioration in liquidity has been around market fragmentation as a result of cross border rules, she said. “For instance, with clients trading in different jurisdictions potentially not wanting to trade with US persons because of being subject to U.S. rules around reporting, or being subject to SEF obligations, so this is one area of improvement where we are excited to hear that the CFTC is exploring.”
She added that while the move from CEM to SA-CCR is also appreciated, SA-CCR “is definitely not a panacea and we would welcome further reform.”
Conversely, Randolf Roth, a member of the Eurex Frankfurt executive board, said that regulation overall has negatively affected markets. “At a macro level, markets are more resilient, robust and efficient if you have different market participants with different strategies and purposes. The big wave of regulation has over-proportionately hit smaller firms; they’re not there anymore, which has reduced quality,” he said.
Taking a positive spin on the panel title, Stephen Berger, managing director, government and regulatory policy at Citadel, said, “I don’t believe there is a liquidity crisis.”
“Over the past decade, innovation and competition, coupled with forward-looking regulatory reforms, have dramatically improved pricing and liquidity conditions in the market,” Berger said. “In many products and asset classes, we’ve brought down barriers to entry, and we’ve allowed a more diverse group of market participants to participate, which has improved conditions for investors, and has made the ecosystem more resilient.”
Chris Edmonds, senior vice president, financial markets at Intercontinental Exchange agreed, saying that the most deep and liquid markets available today have a diverse group of users, which has fostered greater innovation in the industry.
“Whether you’re a speculator in the form of a market maker or a proprietary trading shop, or a commercial end-user, one thing’s for certain: everyone prefers not to trade with someone just like themselves. Because of this, we have seen a shift over time in the granularity in the types of products that we’ve been asked to make available. It’s a challenge in one instance but also a great opportunity,” he said.
Where the panellists were all in agreement was in their concern over consolidation in the FCM space and the need to increase the diversity of market participants.
“The single biggest barrier there is to increasing diversity is access to the markets, given the compression we have seen within the FCM space and the requirements that are in place to open accounts at the FCMs or to expand accounts into new lines, which is becoming more challenging because of capital rules,” said Edmonds.
Rafi added that the increasing costs of technology and compliance are also having an impact on the FCM space. “The margins on the FCM side are getting squeezed significantly. To justify the amount of technology spend that you need to set up an FCM and to run it on a fixed costs basis you need a certain amount of scale. It’s very hard for new entrants to come in and achieve that and run a profitable business in any near-term time frame.”
Steve Crutchfield, head of market structure and electronic trading strategy at the Chicago Trading Company, added, “A really important question to ask in each step along the way, whether it is a possible change to market structure, capital rules or regulation is: is this raising or lowering barriers to entry to our markets? I think it’s worth taking a step back and asking ourselves what we can do to further democratize these markets.”