WASHINGTON, DC–A study by three senior staff members of the Federal Reserve Bank of New York that was recently published in the April 2017 Journal of Monetary Economics has come to the conclusion that regulations — in particular the Volcker Rule and Basel III — have weakened secondary bond market liquidity. While the study was based on corporate bond data, the conclusions apply to the CMBS market, as well.
The study affirmed what the industry largely already knew — which was that regulation had impacted liquidity in the secondary markets, causing structural and seemingly permanent changes. One end result, according to the paper, is that “…[I]nstitutions more affected by post-crisis regulation are less able to intermediate customer needs.”
In practical terms, that means highly-regulated institutions, in particular, broker dealers that are associated with banks, are less able to absorb shocks. In turn, if market volatility spikes, there will be even less capacity than there is now.
To better explain what the study's findings mean for the CRE industry, GlobeSt.com spoke with CRE Finance Council Executive Director Lisa Pendergast and Christina Zausner, head of Industry and Policy Analysis at CREFC. Following are excerpts from the interview.
What are some of the tangible effects the regulations have had on secondary market liquidity?
Pendergast: Over the years we have seen certain secondary market liquidity factors deteriorate as the Volcker and Basel capital rules went into effect. You can see the changes in terms of smaller trading volumes, transaction sizes and relatively greater spikes in volatility — when spreads widen and then take longer to return, especially in non-IG bonds.
At one point prior to the crisis, trading $100 million of CMBS bonds was easily absorbed by the secondary market and it did not create volatility.
Fast forward to today with the Volcker and Basel rules in effect that treat CMBS relatively more punitively than corporate bonds and even than other securitization asset classes. In this environment, executing a $20 million in CMBS trade on a secondary desk may cause consternation.
Now a trading desk would very likely want to complete the transaction in smaller bite sizes.
Post-crisis capital and the Volcker rules started to be implemented in 2014, making it more expensive and more challenging to trade. The Volcker rule prohibited proprietary trading and it knocked out these desks that had acted effectively as additional liquidity providers. The rule, which is considered “unworkable” by many, also reduced most of the market-making business in CMBS and other sectors to client facilitation, crossing buyers and sellers.
As a result of these confluence of rules, most believe that liquidity in the secondary market is greatly reduced today.
Can you quantify the impact?
Zausner: One metric that isn't readily available is the number of traders who lost their jobs over the last few years. We found through informal surveys that roughly as many as a third of secondary market traders in the CMBS sector were let go.
Still, the most important takeaway from these surveys and interviews that CREFC conducted on market liquidity and other regulatory impacts in 2015, 2016 and 2017, was that all of our constituent groups that take part in the CMBS markets (issuers, traders, investors, and others) care deeply about secondary market liquidity. There is a strong consensus among CREFC members that something should be done to restore deeper and more liquid secondary markets, likely through regulatory change.
What about spreads? Where are they and are they healthy?
Pendergast: Today triple A bonds are inside 93 basis points over the benchmark. Clearly we have not gone back to pre-crisis spreads, but they have come in from where they were a year ago when volatility spiked for an extended period. Some of the reduced liquidity in the secondary market has been priced in, but the spread tightening in recent months speaks to the fact that credit quality is considered pretty healthy and the fact that the market is smaller.
Read Don't Fret About The Low CMBS Originations
You didn't mention Dodd-Frank's risk retention rule as one of the culprits. Why is that?
Pendergast: Risk retention is intended to address the credit risk issue, and it is different than the other rules. It is the first time since this market was created in the 90's when participants had to reconsider the structure of a transaction. In fact, the pipeline of transactions waiting for issuance after our conference next week and estimates for 2017 issuance suggest that the primary CMBS market may have figured out how to deal with the risk retention mousetrap, at least in terms of structuring.
The risk retention is different than Basel and Volcker requirements, because it doesn't directly affect secondary market trading and liquidity. While there are many details that will need to be addressed over time, new issuance is not the pain point at this time.
Read A Fresh New Hell for CMBS
Are the regulators waking up to what is happening?
Zausner: We have been talking to regulators about the contraction in market-making for some time and they are coming around to acknowledging that regulations are a big factor in the weaker secondary market liquidity. And it is not too soon either, because there are additional Basel regulations coming online soon, Fundamental Review of the Trading Book (FRTB) and the Net Stable Funding Ratio (NSFR).
The NSFR, in fact, is closer to fruition as it is in the proposed stage in the US, while the FRTB is still at the Basel level.
Though this recent Fed study and other evidence that the regulators at least acknowledge the role of regulation in reduced liquidity, they aren't speaking in unison, or even much at all, about changes. The former Governor of the Federal Reserve who oversaw supervision and regulation, Daniel Tarullo, who said that the Volcker Rule was challenging in his outgoing speech in April, may be one of the only principals to suggest revising or doing away with Volcker.
Pendergast: For now it seems like the regulators will be pressing ahead with their agenda to adopt further requirements; Congress is actively discussing Basel and the Volcker rule. The Financial Choice Act includes provisions that would raise the bar for adoption of Basel capital and liquidity rules here in the US and it calls for the repeal of the Volcker Rule. For its part, CREFC will continue to raise awareness on the subject of market liquidity, the need to rationalize current regulations and the need to vet future requirements more thoroughly.
WASHINGTON, DC–A study by three senior staff members of the Federal Reserve
The study affirmed what the industry largely already knew — which was that regulation had impacted liquidity in the secondary markets, causing structural and seemingly permanent changes. One end result, according to the paper, is that “…[I]nstitutions more affected by post-crisis regulation are less able to intermediate customer needs.”
In practical terms, that means highly-regulated institutions, in particular, broker dealers that are associated with banks, are less able to absorb shocks. In turn, if market volatility spikes, there will be even less capacity than there is now.
To better explain what the study's findings mean for the CRE industry, GlobeSt.com spoke with CRE Finance Council Executive Director Lisa Pendergast and Christina Zausner, head of Industry and Policy Analysis at CREFC. Following are excerpts from the interview.
What are some of the tangible effects the regulations have had on secondary market liquidity?
Pendergast: Over the years we have seen certain secondary market liquidity factors deteriorate as the Volcker and Basel capital rules went into effect. You can see the changes in terms of smaller trading volumes, transaction sizes and relatively greater spikes in volatility — when spreads widen and then take longer to return, especially in non-IG bonds.
At one point prior to the crisis, trading $100 million of CMBS bonds was easily absorbed by the secondary market and it did not create volatility.
Fast forward to today with the Volcker and Basel rules in effect that treat CMBS relatively more punitively than corporate bonds and even than other securitization asset classes. In this environment, executing a $20 million in CMBS trade on a secondary desk may cause consternation.
Now a trading desk would very likely want to complete the transaction in smaller bite sizes.
Post-crisis capital and the Volcker rules started to be implemented in 2014, making it more expensive and more challenging to trade. The Volcker rule prohibited proprietary trading and it knocked out these desks that had acted effectively as additional liquidity providers. The rule, which is considered “unworkable” by many, also reduced most of the market-making business in CMBS and other sectors to client facilitation, crossing buyers and sellers.
As a result of these confluence of rules, most believe that liquidity in the secondary market is greatly reduced today.
Can you quantify the impact?
Zausner: One metric that isn't readily available is the number of traders who lost their jobs over the last few years. We found through informal surveys that roughly as many as a third of secondary market traders in the CMBS sector were let go.
Still, the most important takeaway from these surveys and interviews that CREFC conducted on market liquidity and other regulatory impacts in 2015, 2016 and 2017, was that all of our constituent groups that take part in the CMBS markets (issuers, traders, investors, and others) care deeply about secondary market liquidity. There is a strong consensus among CREFC members that something should be done to restore deeper and more liquid secondary markets, likely through regulatory change.
What about spreads? Where are they and are they healthy?
Pendergast: Today triple A bonds are inside 93 basis points over the benchmark. Clearly we have not gone back to pre-crisis spreads, but they have come in from where they were a year ago when volatility spiked for an extended period. Some of the reduced liquidity in the secondary market has been priced in, but the spread tightening in recent months speaks to the fact that credit quality is considered pretty healthy and the fact that the market is smaller.
Read Don't Fret About The Low CMBS Originations
You didn't mention Dodd-Frank's risk retention rule as one of the culprits. Why is that?
Pendergast: Risk retention is intended to address the credit risk issue, and it is different than the other rules. It is the first time since this market was created in the 90's when participants had to reconsider the structure of a transaction. In fact, the pipeline of transactions waiting for issuance after our conference next week and estimates for 2017 issuance suggest that the primary CMBS market may have figured out how to deal with the risk retention mousetrap, at least in terms of structuring.
The risk retention is different than Basel and Volcker requirements, because it doesn't directly affect secondary market trading and liquidity. While there are many details that will need to be addressed over time, new issuance is not the pain point at this time.
Read A Fresh New Hell for CMBS
Are the regulators waking up to what is happening?
Zausner: We have been talking to regulators about the contraction in market-making for some time and they are coming around to acknowledging that regulations are a big factor in the weaker secondary market liquidity. And it is not too soon either, because there are additional Basel regulations coming online soon, Fundamental Review of the Trading Book (FRTB) and the Net Stable Funding Ratio (NSFR).
The NSFR, in fact, is closer to fruition as it is in the proposed stage in the US, while the FRTB is still at the Basel level.
Though this recent Fed study and other evidence that the regulators at least acknowledge the role of regulation in reduced liquidity, they aren't speaking in unison, or even much at all, about changes. The former Governor of the Federal Reserve who oversaw supervision and regulation, Daniel Tarullo, who said that the Volcker Rule was challenging in his outgoing speech in April, may be one of the only principals to suggest revising or doing away with Volcker.
Pendergast: For now it seems like the regulators will be pressing ahead with their agenda to adopt further requirements; Congress is actively discussing Basel and the Volcker rule. The Financial Choice Act includes provisions that would raise the bar for adoption of Basel capital and liquidity rules here in the US and it calls for the repeal of the Volcker Rule. For its part, CREFC will continue to raise awareness on the subject of market liquidity, the need to rationalize current regulations and the need to vet future requirements more thoroughly.
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Erika Morphy
Erika Morphy has been writing about commercial real estate at GlobeSt.com for more than ten years, covering the capital markets, the Mid-Atlantic region and national topics. She's a nerd so favorite examples of the former include accounting standards, Basel III and what Congress is brewing.
