Fed's Dudley Downplays Bond Liquidity Concerns, Points to HFT

Sep 30 2015 | 4:01pm ET

By Jonathan Spicer (Reuters) - A top Federal Reserve official on Wednesday largely dismissed concerns that bond market liquidity has sharply diminished following U.S. regulatory reforms, saying the rise of high-frequency trading probably plays a bigger role in any changes.

William Dudley, president of the New York Fed and a front-line Wall Street supervisor, said one-off "liquidity events" in which trading of Treasury and corporate bonds becomes significantly more expensive and difficult may reflect the complex interactions of algorithmic trading strategies.

He acknowledged that the riskiness of trading in these markets may have risen. But he largely waved off growing contentions that regulations meant to safeguard the financial system after the 2007-2009 crisis are making things worse.

"The evidence to date that liquidity has diminished markedly is, at best, mixed," Dudley, among the most influential of Fed officials, said at a securities industry event.

"Even if one were to interpret the evidence as indicating that liquidity has been reduced, it is not clear whether regulation is the primary driver, as other changes have played important roles as well," he said, reflecting the arguments of colleagues at the central bank.

Bankers, investors, as well as regulators from the Fed and other agencies have expressed concerns about bouts of bond market volatility, particularly after a "flash crash" on Oct. 15, 2014. Many market participants have blamed crisis-inspired rules requiring more capital, less proprietary trading and stress tests.

Events such as last October's "may reflect unanticipated, complex and dynamic interactions among high-frequency trading strategies that can play out faster than the time frame in which human intervention can occur," Dudley said, adding later that regulations on such activities may be needed given liquidity tends to dry up in times of stress.

The policymaker acknowledged that the Fed's aggressive monetary stimulus, including buying some $3.5 trillion in bonds since the crisis, may affect measures of market liquidity. He also said there may have been an increase in the risk that selling bonds may be more difficult in the future, something known as liquidity risk.

Unlike Treasuries, which largely trade on a centralized order book, corporate bonds are more diverse and traded in smaller sizes on fragmented venues. Dealers are holding far fewer high-yield corporate bonds since the crisis, which is a key source of the overall liquidity concerns.

"Trying to move corporate bonds is very, very difficult," Douglas Peebles, head of fixed income at investment manager AllianceBernstein, said on a conference panel after Dudley spoke. "This is not new. This happened basically in 2007, 2008."

But Dudley had cited order book depth, bid-ask spreads and trade sizes to say "there is limited evidence" that liquidity has dried up.

"We have a financial system that is much more resilient (since the crisis), and the available evidence suggests that this transformation has not resulted in any significant erosion in market liquidity," he said in his speech.


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