With economic recovery uncertain and geopolitical tensions roiling, markets are looking increasingly skittish. Thus, regulators should be wary of adding to the uncertainty with credit market reforms that could further deplete liquidity that is already scarce, warns Ian Russell, president and CEO of the Investment Industry Association of Canada (IIAC).
In Russell's latest letter to the investment industry, he recounts his observations from the latest annual meeting of the International Capital Market Association (ICMA), which took place in early June. His comments suggest that a sense of foreboding prevailed among the conference participants.
"Global credit markets are at an important crossroads, with investors and intermediaries sensing imminent economic and financial adjustment," he says. "The concern among market participants is the magnitude of the shocks could be significant and the follow on impact on capital markets substantial, given the thin veneer of liquidity."
Long-term bond yields have become increasingly volatile, and that this is expected to continue, Russell notes. In addition, currency market volatility is also seen to be increasing as monetary policies diverge in the face of differing recovery trends. There are also worries about China's economy, the risk of default in Greece and renewed tensions between Russia and the West, in the Middle East, and in the South China Sea.
All of these factors, Russell says, are putting pressure on credit market liquidity. Thus, he warns that forthcoming regulatory reforms in credit markets will likely exacerbate the liquidity problem.
These reforms include: efforts to improve bond market transparency; the U.K.'s recent Fair and Effective Markets Review, which makes 21 recommendations for reform in the wholesale fixed-income, currency and commodity (FICC) markets; and plans for unbundling the costs of fixed-income dealing; among others.
"These forthcoming regulatory initiatives have the potential to reduce market-making and further erode already thin liquidity in traded debt markets. Weak secondary markets will likely amplify swings in bond yields once evidence points to either strengthening growth and rising inflation rates, or deteriorating growth and building deflationary pressures," Russell warns. "Interest rate shocks could spread rapidly across asset classes, notably bond [exchange-traded funds], and reinforce further downward rate adjustments as selling pressure builds. The consequences for credit markets could be severe."
Given the market condition, and the magnitude of the risks, Russell advises regulators to proceed with caution in reforming global credit markets.
"These reforms in credit markets are rolling out just as the credit markets are undergoing an unprecedented collapse in liquidity. It is critical that regulators in the European Union, the U.S. and Canada in contemplating new rules, first step back and undertake a full regulatory review of the cumulative effect of post-crisis capital, liquidity, trading rules as well as an analysis of the impact of [the second phase of the client relationship model] requirements in Canada," he says. "It is also important that they proceed with utmost care to avoid further damage to market liquidity and the vulnerability of credit and derivative markets to sharp adjustments in interest rates and asset prices."