"The fallout from the financial crisis and the regulatory response to it may mean liquidity risk getting harder to manage given the reduced willingness of banks and broker-dealers to make markets", said Sarah Breeden, head of the markets, sectors and inter-linkages division in the financial stability unit at the BoE, speaking at an asset management conference organised by the US Financial Stability Oversight Council (FSOC) in Washington, DC. The FSOC is currently weighing whether firms such as Fidelity and BlackRock should be regulated as systemically important financial institutions (SIFIs), which would subject them to Federal Reserve supervision – and Breeden's boss, Andy Haldane, recently described asset managers as the "next frontier" in macro-prudential supervision.
Breeden's comments drew a sharp response from Ken Griffin, founder and chief executive of hedge fund Citadel, who challenged the idea that market-makers have been willing to expose themselves to significant losses by extending liquidity during a falling market. "The idea that our banks or broker-dealers have ever put their capital at risk in a meaningful way in the context of a market correction is a fallacy. The banking system is not in the business of absorbing unlimited losses beyond comprehension to facilitate liquidity provision demanded by participants in the capital markets", he said.
Concerns about the impact regulation is having on market-makers came to the fore in mid-2013, as fixed-income investors cut positions in response to suggestions that the US Federal Reserve might start reining in its bond-buying programme. Many market participants claim this mixture of huge investor holdings and limited dealer risk appetite saw prices fall further and faster than would otherwise have been the case in May, June and July last year. The BoE's Breeden warned worse could follow. These trends could create systemic risks if "the liquidity that is offered to investors is greater than that available in the underlying assets" of the funds they manage, she warned. "Collective investment schemes might do this where they offer daily redemption to investors while investing in illiquid assets, thereby creating a reliance on secondary market liquidity to meet redemptions", said Breeden.
Liquidity mismatches could have exactly the same impact as excessive leverage. "It leads to forced sales, unexpectedly one-sided markets and, if done in size, the possibility of exhausting market liquidity, particularly in times of stress", she said. "That fire-sale risk and market dysfunction can bring the possibility of externalities through to other market participants in the financial system – perhaps if assets are held as collateral in repo markets and in extremis we might have real-economy impacts. So I do see liquidity risk in the sector; I see it rising and I am concerned the system may be potentially less well placed to manage that greater risk." Citadel's Griffin disagreed. "The question at stake is whether asset managers serve to amplify these risks that are intrinsic and inherent in our capital markets", he said. He defended the role of asset managers in the fixed-income markets, arguing the sector has "provided corporate America with a tremendous source of long-term funding that was not historically available in the banking system" and helped fuel the recovery of the US economy after the financial crisis.
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