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Has Something Gone Wrong with Over-the-Counter Markets?

The leverage-ratio rule has reduced market liquidity and distorted dealer incentives for market making. Risk-weighted capital requirements may be the answer.

By Darrell Duffie

Post-crisis increases in the capital requirements of large bank-affiliated dealers have reduced the liquidity of financial markets. The Volcker Rule may also have contributed to a loss of market liquidity. The benefits of a safer financial system associated with higher capital requirements easily exceed the corresponding cost in market liquidity. Nevertheless, a better understanding of the effect of capital requirements could promote some improvements in practice and regulation. In this article, I review some of the evidence on changes in market liquidity and argue that one particular regulation, the leverage-ratio rule,2 has inefficiently distorted dealer incentives for market making and that its financial-stability benefits could be achieved more effectively with risk-weighted capital requirements.

Historically, large dealer banks have been robust providers of liquidity to investors, especially for block positions and for assets traded in over-the-counter (OTC) markets. Before the financial crisis, they maintained large market-making inventories that served the needs of investors seeking quick access to specific assets. Dealers were also ready to quickly make additional space on their balance sheets for clients who wished to liquidate their asset positions. Capital requirements, however, were too low. By absorbing so much risk relative to their capital, most major dealers were a menace to financial stability. When some of the largest U.S. dealers failed or had to be bailed out in 2008, legislators and regulators resolved to restore financial stability with significant increases in capital and liquidity requirements. These new rules reduced the socially inefficient incentives of large dealers, caused principally by being "too big to fail."

The adverse effects on the liquidity of OTC markets caused by capital regulations and the Volcker Rule are partly offset by regulations that have improved OTC market competition.

Despite significant improvements in capitalization, the credit spreads that dealers now pay are much higher than their pre-crisis levels. The creditors of major dealers are now acutely aware that they will be forced to take significant losses when the dealer approaches insolvency, especially through targeted "bail-ins" at its administrative failure resolution.3 This has further reduced the incentives of dealers to build large balance sheets, because debt financing is more costly. Indeed, the market-making securities inventories of bank-affiliated dealers have dropped precipitously.

As another example of balance-sheet pressure, dealers recently began to charge their swap books with "funding value adjustments" that discourage dealer swap desks from entering positions that require significant financing of collateral or up-front payments.4 Dealers have also dramatically increased their use of financial-engineering methods, such as swap compression trading, that economize on the amount of balance sheet space needed to intermediate a given amount of swap trades. To further reduce their balance sheets, dealers have "fired" large numbers of their less-profitable prime-brokerage clients.

Nevertheless, bid-ask spreads have not become wider in all OTC markets. In the corporate bond market, bid-ask spreads have actually narrowed, even relative to their pre-crisis levels, according to numerous sources.5,6,7,8 On the other hand, these same studies show that dealers are not absorbing large block trades as readily and that corporate bond turnover has declined. Helwege and Wang (2016) show that issuers of "mega-bonds" have responded by reducing the sizes of their largest issues.9

When intermediating corporate bond trade requests, research shows10,11 that dealers are now more likely to offer "agency" or "riskless-principal" trades, which delay the execution of a client’s request to sell until the dealer can find a matching buyer.12 Again, this reduces the amount of balance sheet space required to handle a given amount of trades. In effect, dealers are relying more on inventory held on their clients’ balance sheets, and less on inventory that they hold themselves. Various empirical studies have also shown that market returns have become more sensitive to dealer capitalization and to the sizes of dealer market-making inventories.13 Some of these effects are probably not reactions to the Volcker Rule, which is less concerned with balance-sheet space than trading motives. As I have explained,14 the main impediment to liquidity associated with the Volcker Rule is the difficulty of separating legitimately exempted market making from speculative trading that isn’t intended to market markets. Nevertheless, empirical analysis suggests that the Volcker Rule has also reduced the liquidity of the U.S. corporate bond market.15

Effects on Market Liquidity
There has been some confusion about whether or why capital requirements should matter for market liquidity. If capital requirements do matter, would that be a violation of the Modigliani-Miller (MM) Theorem? The most relevant part of the MM Theorem states that the total market value of a firm’s assets does not depend on the firm’s capital structure. Even under its own assumptions, however, MM doesn’t speak to the incentives of a firm to add new positions to its balance sheet. Whenever a dealer adds a new market-making position, even at zero trading profit, the market value of the dealer’s equity can be affected by a change in the riskiness of the dealer’s balance sheet.

For example, adding a sufficiently risky position, even before considering any trading profit, can benefit a dealer’s shareholders at the expense of its creditors, because the limited liability of shareholders allows them to walk away from insolvency at no cost. This leaves creditors with a weaker claim. Jensen and Meckling (1976)16 used the term "asset substitution" to describe this method of exploiting the divergent interests of creditors and shareholders. Even if no single trade has a big impact, the incremental effects can add up subtly over time. Capital requirements reduce or block asset-substitution incentives.

Volumes of trade in Treasury repos have dropped precipitously, especially in the interdealer repo market.

Higher capital requirements also alter an important incentive known as "debt overhang." Debt overhang implies that a trade with a positive mark-to-market dealer profit can sometimes imply a negative return for the dealer’s equity.17 If the trade requires enough new capital relative to the risk of the new position, it may improve the credit quality of the dealer’s debt and correspondingly reduce the equity market value associated with limited liability. An example of this is a pair of back-to-back swaps, fully hedging each other, but requiring the dealer to make a net positive up-front payment or post an additional amount of collateral.

For instance, a buy-side investor may enter a swap with a dealer that the dealer hedges in the interdealer market. Buy-side firms frequently post no collateral with the dealer, but the dealer is required to post collateral for the interdealer swap, whether to a central counterparty or (as required in the U.S. from late 2016, and in Europe beginning at some time in 2017) to another dealer. Financing additional collateral causes a dealer’s creditors to benefit from improved backing, at the expense of the dealer’s legacy shareholders.18 Even if, as is common in practice, the required up-front payment or collateral is funded with unsecured debt, the effective cost to the dealer’s shareholders is significant and equal to an amount known in industry practice as the funding value adjustment. The dealer should enter into such a trade only when it compensates its shareholders with a sufficiently large trading profit, obtained by widening its bid-offer spread. An analogous "capital value adjustment" is required to compensate shareholders for using up some of the dealer’s headroom (available slack) under its regulatory capital requirement. Market-making capital requirements have increased significantly with the Basel19 III "fundamental review of the trading book."

The leverage-ratio rule is a parallel system of Basel-based capital requirements that are not sensitive to the riskiness of a bank’s assets. Under the U.S. supplementary leverage-ratio rule, for example, the largest U.S. broker dealers are subject to a 5% leverage ratio. This means that for every $100 million of additional assets, a dealer is required to have an additional $5 million of capital, regardless of the riskiness of the assets. Under this rule, for example, intermediating U.S. Treasury repos requires a lot of capital relative to the tiny risks involved, and thus improves the position of the dealer’s unsecured legacy creditors. So, with the imposition of the leverage-ratio rule, dealers should increase their bid-ask spreads on repo intermediation enough to overcome the debt-overhang cost to their shareholders. That is exactly what they have been doing. Since the imposition of the supplementary leverage ratio rule, bid-ask spreads in the U.S. Treasury repo market have increased from around 3 basis points to over 16 basis points (see Figure 1). As a consequence, volumes of trade in Treasury repos have dropped precipitously, especially in the interdealer repo market.20

The Clearing HousePerhaps the leverage-ratio rule has also dampened the incentives for U.S. dealers to provide robust levels of liquidity to U.S. Treasury markets. At least, there is some question concerning the causes of the apparent episodic loss of liquidity in this market – in evidence, for example, with the "flash rally" on October 15, 2015, in the 10-year Treasury-note market.21

Europe Vs. U.S.
European dealer banks have recently given up some of their market-making franchises, or at least some market share, to their American competitors. This is a natural consequence of the relatively stronger capitalization of U.S. broker dealers, which implies that the shareholders of U.S. dealers bear a lower cost relative to their European counterparts for allocating balance sheet space to market making. This is related to the "ratchet effect" associated with debt overhang.22 At low levels of dealer capitalization, accommodating new client positions by adding capital (or using up some of the headroom available before additional capital must be raised) is more costly to shareholders than it would be if the dealer’s capitalization is already high. At very high levels of capital, there is almost no debt overhang cost to shareholders for additional market making because creditors are already so safe that there isn’t much more market value that shareholders could transfer to creditors by adding even more capital.

The adverse effects on the liquidity of OTC markets caused by capital regulations and the Volcker Rule are partly offset by regulations that have improved OTC market competition. Chief among these are regulations in support of price transparency. Various empirical studies23 suggest that the imposition in 2003 of post-transaction reporting in U.S. corporate bond markets, through the Trade Reporting and Compliance Engine (TRACE), has generally lowered execution costs for the buy-side customers of dealers. The news here, however, is not necessarily all good. The greater price transparency and narrower bid-offer spreads generally promoted by TRACE could actually have had an adverse effect on market liquidity in some segments of the corporate bond market.24 They speculate, based on their empirical results, that the reduction of dealer trading rents caused by TRACE may have reduced the intensity of intermediation services offered by dealers in smaller, riskier bond issues.

Regulation has also supported competition by forcing the migration of market-making services for some standardized products, such as plain-vanilla interest rate swaps, onto multidealer electronic trade platforms, where dealers must post prices in direct simultaneous competition with each other.25 Prior to regulation, multidealer OTC-market trade platforms were used primarily for interdealer trade. In the European Union, the Markets in Financial Instruments Directives require platform-based dealer competition across a wider range of markets, including bonds and swaps.

Have legislatures and regulators gotten us close to the "efficient regulatory frontier," at which we would have the highest possible financial stability for a given level of market efficiency? It seems relatively clear to me that, with regard to the leverage-ratio rule, this is not the case. There is an opportunity to make adjustments that would achieve more financial stability for the same level of market efficiency, or, alternatively, more market efficiency for the same level of financial stability. For example, relaxing the application of the leverage-ratio rule for extremely safe and economically important intermediation activities, such as conservatively managed matched-book dealing in Treasury repos, would have essentially no impact on the stability of large bank-affiliated dealers and would alleviate an important distortion in this critical market. The U.S. Treasury repo market is an important determinant of the pass-through efficiency of U.S. monetary policy26 and anchors the financing and hedging needs of investors in U.S. Treasury securities.

The Bank of England recently noted the unintended adverse consequences for market efficiency caused by applying the leverage-ratio rule to central bank deposits, another very safe asset. The Bank of England responded appropriately by making an exemption.27

An alternative route toward the efficient regulatory frontier would be via an increase in the risk-weighted-asset (RWA) capital requirements of large banks, enough that the leverage-ratio rule has no significant likelihood of becoming a binding constraint on a dealer bank’s capital, even under an application of regulatory stress tests. While imperfect and subject to incentive concerns,28 RWA capital requirements are less distortionary than the leverage-ratio rule, and they’re at least as effective in promoting financial stability if set conservatively. In the current political environments of the United States and Europe, however, the opportunity to move regulations in the direction of higher RWA capital requirements relative to leverage-ratio requirements seems to be getting more remote.


1 This lecture, hosted by TCH and the Stern Center at New York University, was given at NYU on April 13, 2016. I am grateful for conversations with Tobias Adrian, Yu An, Leif Andersen, Wilson Ervin, Arvind Krishnamurthy, Hyun Shin, Yang Song, Marti Subrahmanyam, Suresh Sundaresan, Chaojun Wang, and Yao Zeng. I am particularly grateful for advice from Bruce Tuckman. Author’s web page:

2 See Basel Committee on Banking Supervision (2014).

3 Duffie, Darrell."Market Making Under the Proposed Volcker Rule," Rock Center for Corporate Governance at Stanford University Working Paper, Report to the Securities Industry and Financial Markets Association, and Submission to the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission (January 2012).

4 Andersen, Leif, Darrell Duffie, and Yang Song. "Funding Value Adjustments," working paper. Graduate School of Business, Stanford University (2016).

5 Adrian, Tobias, Michael Fleming, Or Shachar, and Erik Vogt. "Market Liquidity after the Financial Crisis." Federal Reserve Bank of New York Staff Report Number 796 (October 2016).

6 Bessembinder, Hendrik, Stacey Jacobsen, William Maxwell, and Kumar Venkataraman. "Capital Commitment and Illiquidity in Corporate Bonds," working paper. Arizona State University and Southern Methodist University (2016).

7 Fender, Ingo, and Ulf Lewrick. "Shifting Tides – Market Liquidity and Market-Making in Fixed Income Instruments." BIS Quarterly Review (March 2015): 97-109.

8 Mizrach, Bruce. "Analysis of Corporate Bond Liquidity," research note. FINRA Office of the Chief Economist (2015).

9 Helwege, Jean, and Liying Wang. "Liquidity and Price Pressure in the Corporate Bond Market: Evidence from Mega-Bonds," working paper. Anderson Graduate School of Management, University of California, Riverside (January 2016).

10 Trebbi, Francesco, and Kairong Xiao. "Regulation and Market Liquidity," working paper 21739. NBER (2015).

11 Bessembinder et al. (2016).

12 Ederington, Guan, and Yadav (2015) empirically separate agency and principal-at-risk execution costs. Ederington, Louis, Wei Guan, and Pradeep Yadav. "Dealer Spreads in the Corporate Bond Market: Agent Versus Market-Making Roles," working paper. Univ. of Oklahoma (2015). Further evidence on bid-ask spreads and the heavy use of riskless principal trades is provided by Harris. Harris, Larry. "Transactions Costs, Trade Throughs, and Riskless Principal Trading in Corporate Bond Markets," working paper, USC (2015).

13 Amihud and Mendelson (1980) and An and Zheng (2016) model the effects of inventory costs on bid-ask spreads and the incentives for immediacy provision. That dealer capital levels and market-making inventories have an important effect on market returns is supported in a wide range of empirical work, including Adrian, Etula, and Shin (2009), Adrian, Moench, and Shin (2011), Comerton-Forde, Hendershott, Jones, Moulton, and Seasholes (2010), Etula (2009), and Friewald and Nagler (2015).

14 Duffie, Darrell (2012).

15 Bao, Jack, Maureen O’Hara, and Xing (Alex) Zhou."The Volcker Rule and Market-Making in Times of Stress," working paper. Finance and Economics Discussion Series Divisions of Research and Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C. (September 2016).

16 Jensen, Michael, and William Meckling. "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure." Journal of Financial Economics 3 (1976): 305-360.

17 Myers, Stewart. "Determinants of Corporate Borrowing." Journal of Financial Economics, Volume 5 (1977): 147-175.

18 Andersen, Duffie, and Song (2016)

19 See Basel Committee on Banking Supervision (2016).

20 Martin, Antoine. "Reform, Regulation, and Changes in the U.S. Repo Market," presentation. FRBNY (April 2016).

21 See U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Securities and Exchange Commission, and U.S. Commodity Futures Trading Commission (2015).

22 Admati, Anat, Peter DeMarzo, Martin Hellwig, and Paul Pfleiderer. "The Leverage Ratchet Effect," working paper. Graduate School of Business, Stanford University (2016).

23 See Asquith, Covert, and Pathak (2013); Bessembinder and Maxwell (2008); Bessembinder, Maxwell, and Venkataraman (2006); Edwards, Harris, and Michael (2007); and Goldstein, Hotchkiss, and Sirri (2007).

24 Asquith, Paul, Thomas Covert, and Parag Pathak. "The Effect of Mandatory Transparency in Financial Market Design: Evidence from the Corporate Bond Market," MIT working paper (Sept. ’13).

25 Zhu (2012) models the reduced dealer competition available to buy-side firms who must obtain quotes from dealers bilaterally, one at a time, as in conventional OTC markets. Zhu, Haoxiang. "Finding a Good Price in Opaque Over-the-Counter Markets." Review of Financial Studies 25 (2012): 1255-1285.

26 Duffie, Darrell, Arvind Krishnamurthy. "Passthrough Efficiency in the Fed’s New Monetary Policy Setting," working paper. Presentation at Jackson Hole Symposium, FRB Kansas City (Aug. ’16).

27 "Financial Policy Committee Statement from its Policy Meeting, 25 July 2016." Bank of England (Aug. 4, ’16).

28 See, for instance, Colliard, Jean-Edouard. "Strategic Selection of Risk Models and Bank Capital Regulation," Working Paper Series. European Central Bank, HEC Paris (August 2014).

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