When I studied organizational theory at MIT, I unsurprisingly learned to think like an engineer. One important lesson: truly complex systems cannot fail from single causes because built-in redundancy prevents this. Instead, complex systems fail for complex reasons. Another engineering lesson: if the engine is coughing, it’s broken even if none of the red lights is blinking – the lights could be your problem, not the engine. All of this may seem intuitively obvious, but the vigorous and sometimes even vicious debate over market liquidity seems to be missing both of these points.
In the last few weeks, we have had various treatises on several liquidity near-misses – think of these close calls as sputtering engines. FSOC provided us with lots of cool charts that concluded nothing much other than that lots more charts with still more data are needed. In short, fly on while we think about rewriting the manual. An industry-sponsored paper concluded that market illiquidity is seizing up largely due to a single cause: new rules. Loosen them, it suggests, and markets will flourish anew. Happily, new work by the Federal Reserve Bank of New York over the course of the week paints a more complex picture than either FSOC or the industry paper, befitting the complex market infrastructure that causes illiquidity.
As analyzed in our daily alerts, the FRB-NY posts explore several possible illiquidity drivers, most notably significant technology changes. Based on its analyses, the FRB-NY posits three causes in the primary-dealer chain: post-crisis prudence, the growing role of HFT, and – yes – regulation.
This view is better, but still insufficient because the regulatory framework driving market illiquidity is more complex than suggested by its leverage charge. New liquidity rules are a critical market driver – stagnation in part derives from all the high-quality, liquid assets marooned on banks’ books to meet the LCR and, soon, the NSFR. Because the leverage rule is particularly devastating on these assets, the two rules combine to create a liquidity train-wreck from a bank balance-sheet perspective.
Advocates of very high leverage and liquidity rules argue that these make markets safer. All things being equal, this would be true, but only if one could return market engineering to the structure it exhibited in, say, 2000. Of course, we can’t – the FRB-NY’s work on what it calls “electronification” shows this very clearly. As a result, market illiquidity can even be made worse by regulation, just as an engine can be made far more dangerous if you ground some planes and allow others to take on still more passengers, flying high with stripped-out internal controls.
Will markets crash? FSOC, Treasury, and the FRB suggest we should be watchful, but not over-worried. The solution each has most recently presented to all the market’s coughs and sputters is more research. That’s fine – the more we know, the smarter we are. We can spend the next two years debating which number best measures liquidity and which fixed-income market should worry us the most.
However, like O-Hare at rush hour, markets are unforgiving. As the last couple of days have demonstrated, the margin for error in key fixed-income markets is as thin as the distance between landing and take-off in a thunderstorm. Policy-makers watch the controls without looking out the window at great peril to us all.