WASHINGTON — Nearly five years after the passage of the Dodd-Frank Act, regulators are beginning to question whether the cumulative effect of the rules authorized by the law are hurting market liquidity — and if that could pose a systemic risk.

Speaking before the Brookings Institution this week, Office of Financial Research Director Richard Berner said that the financial reform law and related regulations could "be contributing to more permanent adjustments that could impair market functioning," including by reducing market liquidity.

Berner said that some reduction in liquidity is by design — mortgage-backed securities, for example, are intentionally more difficult to trade now than they were before the crisis. Cyclical factors are also at play while the advent of high-frequency trading in the bond and derivatives markets appears to aid liquidity in some cases and restrict it in others. But regulators simply do not know enough about how those factors are interacting with each other, Berner said.

"We don't have all the answers about the causes of this decline in market liquidity," Berner said. "Frankly, we need to do a lot more work in understanding what those causes are and how they interact before anyone can meaningfully suggest the right policy response."

Federal Reserve Gov. Daniel Tarullo, speaking at a conference in New York City a week earlier, said that more research needs to be conducted and that the central bank is already devoting resources to examining the issue. But he cautioned that liquidity is relative, and if industry groups are bemoaning the difficulty in making transactions compared to conditions before the 2008 financial crisis, they may be chasing a mirage.

"If your implicit point of comparison is 2006 — when liquidity was super-abundant — I suggest that's not a particularly healthy point of comparison," Tarullo said. "Liquidity was easy to come by then — it turned out to be substantially illusory once there were stresses and once there was any sort of shock."

Market liquidity is a broad term that can mean different things in different contexts. In general, a liquid asset is one that can be easily and quickly converted to cash or some other product, whereas a liquid market is one where that conversion can easily take place. Market liquidity is measured in a number of different but imperfect ways — by total numbers of daily orders, tightness of bid-ask spreads, or "market turnover" (the number of transactions compared to the total number of instruments in the marketplace).

Broker-dealers' traditional role in markets has been to "catch a falling knife" — that is, in a moment of market volatility, they will step in and buy, holding those assets until the market recovers and they can sell those positions.

The financial industry has long complained that the regulatory burden imposed by Dodd-Frank has dried up or fragmented liquidity across a number of markets. The Volcker Rule, for example, is often criticized as having negatively impacted a wide variety of markets because banks — once the counterparties of choice — are either forbidden or discouraged from participating. By law, the Volcker Rule even included an exemption for market-making activities based on fears that if banks exited certain markets, those transactions would disappear.

But the Volcker Rule is just one of the many rules at play when it comes to liquidity. The Fed, Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation issued a final "supplementary leverage ratio" in September that required the largest U.S. banks to hold 5% capital to cover their exposures (and 6% if the bank is FDIC insured). Those same agencies also finalized a "liquidity coverage ratio" in October requiring large banks to maintain a buffer of high-quality liquid assets sufficient to maintain operations for 30 days.

Those rules were mandated in the Basel III accords, and proponents say they have made financial institutions far more resilient to shocks than they were pre-crisis. But critics argue those rules have driven demand for treasuries and agency bonds in a way that has fundamentally altered the market.

Greg Baer, managing director and head of regulatory policy at JPMorgan Chase, said at an industry conference Tuesday that capital rules and other regulatory changes have obviously changed markets. The move to mandatory clearing for derivatives has made central counterparties bigger players in that market, the advent of electronic high-frequency trading has changed the liquidity landscape, and capital requirements have sidelined banks from the markets in new ways. It is therefore difficult to assess market liquidity and make knowledgeable conclusions about overall financial or systemic risk, he said.

"It's a very noisy environment to assess what's going on in market liquidity," Baer said. "Risk either is reduced, or passed along, or it can go somewhere else. And the ultimate question for regulators I think is, 'If you're going to have it move out of the banking system, where does it go, and how do you feel about that?'"

Adam Gilbert, Financial Services Global Regulatory Leader at Pricewaterhouse Coopers LLP, said during a conference June 9 that the consulting firm is poised to release a new study soon on the effect of macroprudential Dodd-Frank regulations on market liquidity. Gilbert said the preliminary results, based on data analysis and a survey of several dozen financial institutions, show that there are at least some tangible liquidity concerns in certain markets.

The report says that in the foreign exchange and equities markets, participants are concerned about "depth" — meaning their ability to make large transactions as easily as more incremental trades. Gilbert also said the report unearthed fears that the brokers who dominate the secondary markets in bonds and other products will simply disappear in a stress event. The report found that fund managers in bond markets are carrying "as much 20% cash" in response to those concerns, according to Gilbert. PwC later clarified that the report suggests that bond fund managers' cash inventories are closer to 10%.

"They think that cash that has been flowing into robust primary markets are masking some of the underlying structural weakness in secondary markets," Gilbert said. "There's concern that this structural change in the market will work against us, not for us."

But Tarullo said that, while there are a number of ways of measuring liquidity, there are few ways of reliably predicting whether it will be available during the stress periods when it is needed the most. Pre-crisis markets were highly liquid, but also were highly leveraged and undercapitalized, and when stress took hold, all that market activity came to a halt.

"You ended up with a lot of daggers out there that very few people were willing to catch," Tarullo said. "I don't know whether that phenomenon changes very much from stress period to stress period no matter how much liquidity seems to be available in normal times. People in general are not disposed, understandably, to catch that proverbial falling knife."

Regulators are still examining the issue. The Financial Stability Oversight Council — which is charged with identifying and addressing sources of systemic risk — said in its May 2015 annual report that changes in market structure could pose liquidity challenges, specifically as it relates to the increased prevalence of high-frequency trading. The report said that while HFT and algorithmic traders have expanded the overall numbers of trades in the Treasury securities, agency and corporate debt, mortgage-backed securities, and related derivative markets, traditional broker-dealers have significantly reduced their inventories, leading to concerns that "broker-dealers are less willing or unable to intermediate supply and demand imbalances."

Kevin Walsh, the OCC's deputy comptroller of the currency in charge of market risk, said that his office has observed similar effects and is concerned about the effect of illiquid secondary markets in a crisis.

"Issuance and appetite to purchase new capital markets instruments across all different asset classes … seems very robust," Walsh said. "The issue that we need to think about with the LCR, swap margin rule and Volcker … is secondary market liquidity. They are very different things."

Walsh went on to say that the Senior Supervisors Group — whose members include senior regulators from the Fed, Treasury, and their counterparts from around the world — are meeting at the New York Federal Reserve Bank the week of June 15 to address market structure and other issues. The New York Fed could not confirm the meeting.

Bank of England Gov. Mark Carney also addressed the issue this week, saying in a speech on Wednesday that the U.K.'s Financial Policy Committee and the international Financial Stability Board are both attempting to parse out the causes of illiquidity in the fixed income markets. But he cautioned that some sluggishness is a fair trade for a more resilient financial system.

"More expensive liquidity is a price well worth paying for making the core of the system more robust," Carney said. "However, the possibility of sharp, unpredictable changes in market liquidity poses a clear risk to financial stability."

Karen Shaw Petrou, managing principal of Federal Financial Analytics, said that it's clear liquidity in fixed-income markets has been impaired, though it's uncertain how much of that impairment is due to regulation, algorithmic trading, low interest rates or other factors. Regardless of the cause, she said, there are some things that have been suggested as possible actions regulators could take to improve liquidity if they chose.

For one, regulators could revise certain aspects of the Basel III accords, specifically the rules outlined in the supplemental leverage ratio. The 5% capital requirement for investment-grade single-named credit default swaps and 10% capital charge for high-yield swaps is making those products too expensive to trade, Petrou said, though demand for them persists. Petrou said another idea that has been floated, albeit a problematic one, is making the Fed "market maker of last resort," effectively having the Fed step in and create liquidity if no one else will.

Petrou said the most specific action regulators should take is to create an exemption from the supplemental leverage rule for excess reserves held by custody banks at the Fed and on cash. The application of those rules to custodian banks hampers their ability to offer liquidity without any apparent reduction in systemic risk, Petrou said, but because creating such a carve-out would be politically unpopular, it is unlikely to be adopted.

"It makes it very hard for the biggest banks — especially the biggest, lowest-risk banks, which are the custody banks — to serve the liquidity role they are built for," Petrou said. "This is an understood unintended consequence, folks are just afraid to touch it because they fear it would be seen as watering down the leverage rule, and somebody on the Hill will bite them."

Petrou argued that some of the Basel III and Dodd-Frank rules have contributed to reduced liquidity, and that those effects are creating gross irregularities in traditionally sleepy markets like bonds and treasuries. And while regulators are concerned about parsing apart how much of a contribution rules have played relative to other factors, they should be more concerned about how they can improve market resiliency.

"Some of the causes are regulatory-driven," Petrou said. "You cannot say — and I do not say — that all of them are, but … if you wait for the perfect analytic, it's going to be too late."

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