It's not just the triggers we need to worry about ......


ref :- " Italian rout points to strains in post-crisis regulatory structure" , The Financial Times , Markets and Investing

Liquidity ..... or the lack of it ..... is a topic that in the past we've banged on about quite regularly but we haven't really exercised ourselves on the subject too much recently. Perhaps one needs a bit of a crash to be reminded that these problems very rarely just go away, but can lie forgotten until the next bout of market panic. The meltdown in the Italian bond market this week is a perfect example of just such a scenario, but the problem is a global one and can affect other asset classes at least as badly as it affects bonds.

We've only really got the time to point you to the FT article, which nicely discusses the wider issues but of course, takes its cue from this week's Italian action. For example : the Italian Government 2yr bond (BTP) yielded about 50bp at the end of last week ..... at the top of it's spike on Tuesday, it yielded close to 2.90bp, and now trades at about 77bp. The logic behind a sell-off in bond prices (spike in yields) was sound enough -- goodness knows we've discussed the political situation in Rome enough -- as is the recovery. (Mind you, apart from the relief factor we find it difficult to be optimistic about the effects that a fiscally free-spending coalition government will have on Italian assets already coping with a debt to GDP ratio of 132%).

What did come as something of a surprise was the extent of the moves, and of the spike in volatility. Perhaps it shouldn't have ..... after all, the cause of these excessive moves -- lack of liquidity -- is hardly a brand new phenomenon, as we say. It manifests most obviously in the BID / OFFER spread ..... the gap between where somebody is prepared to sell and someone is prepared to buy. In the case of the 2yr BTP, that gap has been averaging 3 or 4 bp of late and is often as narrow as 2bp in quiet conditions. This week, the spread blew out to 13bp and in the most panicky moments could be wider than that. There is also an alarming lack of depth to the market ..... i.e. once the bid has been hit, there is a lack of supporting bids beneath it.

The reasons behind all this are hardly revelatory either ..... post-crisis regulation has made it too expensive for most banks to continue their role as market-makers, acting on both the bid and offer sides of the market and providing the required liquidity. That role has been taken on (well, sort of..) by electronic / algorithmic traders. Trouble is, when things start to move violently, those traders disappear. Those looking to sell in a hurry can be left without a bid in sight -- that's when prices can really take a pearler.

Most traders have got some nasty memories along similar lines. Executing STOP LOSS orders, for example. That awful feeling of having to sell when you feel the bid is far too low, and suspect that the price will bounce once the panic subsides a little but being OBLIGED to sell to the first available bidder and not daring to do otherwise .... just in case the market carried on going down the tubes. It's not a new thing, it's always been like that even when we were trading by phones, or in open outcry pits. It's not a technology problem ..... it's a regulatory one and one that revolves around the nature of the traders that replaced the ones that regulation has scared away.

It's an opportune time to be revisiting this subject, just as banks in the States (with the considerable support of President Trump) seem set to secure some rolling back of the Volcker rule. This rule was brought in after the financial crisis to stiffen the security of the banking system (and protect its clients) by stopping banks from propriety trading with depositor funds ..... which of course put a stop to market-making as we know it (or more accurately, knew it).

It's hard to argue that some repeal of the Volcker Rule is not in order, especially with regard to liquidity issues, but those calling for a root-and-branch rollback of regulation need to be very careful. As John Authors points out in SMART MONEY elsewhere in the FT, the Volcker rule and other legislation was introduced as a result of the last financial crisis IN ORDER TO PREVENT THE NEXT ONE. If you advocate throwing out ALL the new rules because you believe that the crisis is over , just remember that it'll be no good trying to reimpose them when the next one occurs ..... it'll be too late.

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