Toward a robust dealer system of first resort

Goldman Sachs takes “A Look at Liquidity”, and tells us what they see.  Suffice it to say that different people see different things, depending on their vantage point, like the proverbial blind men touching the elephant.  Let’s see if we can construct a picture of the animal as a whole from the snapshots provided.

What seems clear is that the bank dealer system of the past is now gone (notwithstanding last-ditch pleading to bring it back).  Banks are largely out of that business, guided by new regulations (specifically the “non-risk-based leverage and liquidity rules”), but also motivated by their own experience with the crisis.  Banks do not want to be in the position of requiring emergency support from the Fed any more than the Fed wants to be in the position of providing that emergency support.

Ever since the crisis, central banks have been standing in for the pre-crisis bank dealer system, flooding the system with funding liquidity.  World-wide QE has essentially bought time for a new more robust dealer system to begin rising from the ashes of the old.  However, at the moment that new system is far from complete, even as central banks (led by the Fed) are signalling that they will not be around forever.  In normal times the central banks supports the market; only in crisis times does it become the market.  What will the new normal times look like?

Steve Strongin talks about how the Fed might respond to the next crisis:  “the Fed might have to buy the distressed assets directly and/or other parts of the government might have to step in” (p. 5).  That is of course how the Fed responded to the last crisis, as I have myself recounted in my book New Lombard Street.  But the necessity for that response shows exactly the inadequacy of the old dealer system–it was not a robust first resort system.  That’s why we have junked the old system.  The question is whether we can rely on the emerging new system to be more robust.

There is a lot of hype about electronic exchanges, and also Exchange Traded Funds, and some of the hype is warranted.  Yes, to the extent that we can make it easier for buyers and sellers to find each other and do business directly, we can do without the now-missing dealer intermediary.  In effect, all such measures work by making the broker function more efficient, which is fine if markets are balanced.  “But the largest problems are likely to arise when markets are not balanced and under significant net selling pressure…” (p. 5)

Just so, consider Blackrock’s Richie Prager on the ETF:  “If supply exceeds demand, the ETF wrapper is unzipped and underlying securities are delivered to the market, thereby reducing the number of ETF shares.  Given these mechanics, even in an extreme scenario, you could unzip the wrapper and be left owning the bonds” (p. 9).  Golly!  The asset manager who wants to sell the ETF is supposed to be calmed by the thought that he now owns the underlying illiquid bonds?  I think not.  Long before that happens, the sponsor of the ETF will be pressured to support its creation by absorbing the net flow on its own balance sheet, which is to say by acting as a dealer not a broker.

The problem is, as Strongin points out, that supporting markets in this way requires the ability to expand your balance sheet on both sides, buying the unwanted assets and funding that purchase with borrowed money.  The ability of banks to do that on their own account is now severely limited.  And it is not even clear that they can readily provide the funding liquidity for someone else, i.e. Blackrock, to do it.  Without Strongin’s “dynamic balance sheet expansion”, the result will be Prager’s “discontinuous pricing and greater volatility” (p. 9).

Why should we care?

One reason is efficient pricing, as Himmelberg and Bartlett point out.  “Without improvements in single-name liquidity, the feasibility of active portfolio management and hence market efficient will necessarily suffer” (p. 7).  For an economist, this argument has an almost irresistible appeal.  We habitually imagine a world of perfect liquidity and efficient pricing, in which only tiny fluctuation in price is required to bring forth demand or supply as needed to clear markets.  Unfortunately, in the real world, the value investor makes the outside spread not the inside spread, buying only when it is a bargain, i.e. when price is clearly less than value.  Value investors are liquidity providers of last resort, but if we rely on them for market liquidity, then prices will be discontinuous, jumping to the outside spread whenever there is imbalance in order flow.

The more important reason we care is that we are worried that discontinuous pricing and greater volatility can get out of hand, and if they do then the Fed is going to have to once again serve as dealer of last resort.  Let me repeat what I said above:  No one wants this, not the banks and not the regulators.  But also no one has a very good idea how to avoid it.  We are in uncharted waters, inventing new things.

At this juncture it would be helpful, I think, to have in mind the bigger picture, which is the evolution away from a bank-based credit system toward a market-based credit system, more suited to a world of financial globalization.  (The enormous expansion of corporate bond issuance since the crisis has only accelerated that shift.)  Today, as before the crisis, marginal credit in the global system is provided by shadow banking, “money market funding of capital market lending”.  In this system, pricing of the capital asset is crucial since typically that asset serves directly or indirectly as collateral for the funding.  And pricing requires market liquidity.  In this system, prices that gap wide from true value during stress times have the effect of freezing up the flow of credit, for everyone.  This is not a guess, but rather an observation from recent experience.

That said, it is also true that discontinuous prices and volatility are strong profit incentives for developing a new and robust dealer system, outside the banks.  And there are signs that such a new system is in fact developing, though such signs are easily missed if our vision is distorted by pre-crisis institutional priors.  What is important is not the survival or profitability of the entities we have grown used to calling “dealers”.  What is important is the survival and profitability of the activity of dealing and market-making, wherever it is happening in the system.   What is important is the existence of balance sheets that can and will absorb temporary mismatch of supply and demand, so reducing discontinuity and volatility, for a price.

The problem faced by central banks today is most analogous to the problem faced in transitioning from war conditions to peace conditions.  They need to withdraw in order to make room for private market-makers, but not so fast that the market collapses and not so slow that no one enters.  That’s the challenge facing Janet Yellen and her colleagues today, as it faced William McChesney Martin in 1952.