Market liquidity drained by regulations, says DBS chief

A host of new regulatory requirements governing financial institutions' trading activities has significantly restricted banks' capacity to absorb risk and provide liquidity, according to Piyush Gupta, chief executive officer at Singaporean lender, DBS.

Speaking at the 11th Asia Risk Congress on September 9 in Singapore, Gupta pointed to Basel III capital requirements, Dodd-Frank and the Volcker rule as all combining to negatively impact market liquidity.

"It is quite clear that the new capital requirements on both macro and asset class levels have had a profound influence on the nature of banking business. Banks have been restricted from doing many transactions as they did before. It has created some unintended consequences – drying out market liquidity."

Gupta said this was occurring even in the most liquid asset classes such as 10 and 20 year Treasury bonds, which have seen noticeable spread widening since the new rules began to take effect.

"Some previously very liquid assets, such as US Treasury bonds, [have seen their yield increase] by 10 to 20 basis points. You may have argued the liquidity issue is a result of high-frequency trading and computer technology, but we should realise that the rule structure is contributing to the challenge. In the coming three to five years, you would see more of this kind of challenge coming up in the banking sector," says the DBS chief.

The new capital requirements on both macro and asset class levels have had a profound influence on the nature of banking business

Andrew Ng, head of treasury and markets at DBS, echoed Gupta's views at a session held later in the day. He said the increasingly onerous regulatory treatments have forced a number of market-makers to shut down their market-making business in Asia and contract risk warehousing capacity, meaning liquidity has evaporated from the market.

"In the past you had banks acting as a market risk absorber. Now because of balance sheet constraints, their risk appetite has dropped significantly. Banks simply cannot provide enough liquidity to the market any more," he said.

To support his point Ng pointed to the sharp reduction in bond inventory held by global banks since the start of the financial crisis. In 2007, the 10 largest banks in the US held $270 billion in corporate bonds, but now they only hold $30 billion, he said.

At the end of 2014, the total value of outstanding repurchase agreements (repo) on banks' books was $6.23 trillion, a 4.8% drop on the figure in June 2014, according to the International Capital Markets Association. The fall is a result of the imposition of the leverage ratio, which is calculated on net basis, making this type of low-margin, high-volume trade less economical on banks' balance sheets.

According to Ng, this lack of liquidity has been particularly problematic during the recent bout of currency market turbulence. As banks must now price higher liquidity premium into trades, the cost of trading dollar/CNH derivatives has increased.

"If you want to clear $200 million USD/CNH contracts, it costs 150 pips now. Previously it was only five pips. In the past few years, because of zero or low volatility, many people mispriced liquidity risk faced by them, now they really need to be more serious about it," said Ng.

The liquidity shortage has also forced buy-side players to scale down their fund sizes and break block trades into smaller sizes in order to close transactions, Ng said.

"In the last couple of months if you were running an Asian macro fund, if your fund size was too big or just used one or two strategies, you probably couldn't get out. Previously if you wanted to clear half a million dollars of interest rate swaps DVO1 [a method to measure interest rate risk associated with swap trading books], it took 10 to 15 minutes, now you need to do it in five days. That's the liquidity you have," Ng said.

While liquidity is evaporating from the market in Asia, wealth management is ballooning. The growth in this imbalance between supply and demand is part of the unintended consequences of the new raft of regulations, Ng said.

This article first appeared in sister title Asia Risk.