The new inter-agency paper assessing Treasury-market liquidity has stoked more controversy than it resolved, a common consequence of reports that are as much a reflection of inter-agency compromise as actual policy findings. As is often the case, we found the substantive, factual discussion in the body of the paper more illuminating than the carefully-hedged “next steps” concluding the hard work of the Treasury, Federal Reserve, SEC, and CFTC. As detailed in a recent FedFin report, key market and policy implications include:
- Treasury and FRB resistance to any change in the U.S. leverage framework trumped efforts by the CFTC to assess the extent to which it has curtailed market liquidity and thus could fire up future flash crashes. More flexibility may be possible on pending rules that are less of a political third rail (i.e., the FRB’s systemic limits on counterparty credit risk) and even aspects of the margin rules. Importantly, Chair Yellen yesterday signaled – albeit tentatively and noncommittally – some flexibility on leverage standards for segregated margins.
- The greatest near-term policy challenge to high-frequency trading is regulatory constraints on self-trading. This may not be all bad for the algos since self-trading creates little actual trading value when programming turns high-frequency trading inside out on both sides of spiraling transactions. Parsing all this self-trading to determine the extent to which it slowed futures-market execution and, thus, poses systemic operational risk will, though, prove still more challenging, as will continued examination of their impact on market liquidity.
- Leveraged Funds: As we have noted, global and U.S. regulators are moving from SIFI designation for investment companies to an assessment of risky activities and practices. The SEC has acknowledged that leverage, especially in ETFs and certain other fund structures, poses an array of risks, risks also highlighted in the market-illiquidity report. As a result, a targeted focus on leveraged funds is in the cards. The SEC has moved leverage-capital standards off the priority list for broker-dealers, also strongly resisting this FSOC idea for investment companies. However, targeted capital standards – leverage or risk-based – should not be discounted for sub-classes of investment companies.
It is very clear that the inter-agency report has not quelled market volatility, resolved policy-maker concerns, or settled the issue for Congress. An array of analytical and advocacy actions are thus sure to follow. We would be pleased to discuss possible next steps, including with regard to building on the new report to develop specific business and policy initiatives. You may find out more about our practice by calling 202-589-0880 and asking for Arezou Rafikian.