Week InReview: March 1, 2019

People are worried about bond market liquidity

The standard story of bond market liquidity is:
  1. Big banks used to trade bonds by buying a large slug of bonds from a customer and holding on to them for as long as it took to find another buyer, smoothing out the market but also taking a lot of price risk for themselves.
  2. Since the financial crisis, new regulations (higher capital requirements, rules against proprietary trading, etc.) have made it more difficult for banks to trade bonds on their own books as dealers.
  3. Instead, banks have just matched up buyers and sellers without intermediating risk themselves, which is less convenient for the buyers and sellers. Also if anything goes wrong, the banks will not be there to take on their historic dealer role of smoothing out price moves, and there could be an ugly crash.
  4. People who do not want there to be an ugly crash tend to think this is bad.
  5. Other people think it is fine, though: If bond prices go down and someone has to lose some money, much better for it to be long-term fundamental bond investors with stable funding than for it to be banks. Banks are systemically risky, as we know, because losses at banks caused a massive systemic crisis in 2008.
I'm not saying that this story is true, and you could object to many of the particulars, but it gives you a rough sense of the controversy. In simplest form, the controversy is that post-crisis regulation has made the financial system safer at the cost of making the market worse. That might or might not be a good tradeoff, depending on the magnitude of the two effects — both quite hard to measure! — but it intuitively seems like it could be a real tradeoff.

— Matt Levine's Money Stuff

Read entire Week InReview: March 1, 2019