Downside of Better Information

I tend to focus on the intricacies of finance because it is so heavily regulated. I use to work in the bond market for many years and know firsthand the impact of bond yields and economic activity.

Bond Market

Banks use to be the hub of bond trading playing an important role in distributing and allocating risk, but as a result of the changes in 2008, namely the Volcker rule, banks play less of a role in the market. Given the destruction of the markets in 2008, banks were told that going forward banks would have to carry much less risk and have much smaller bond portfolios. The result of this is that when banks are asked to trade bonds now, they have  much less inventory to offer and when they buy bonds, then can only buy much smaller amounts now.

So larger trades that use to take place with ease, take much longer now. Pension funds and banks can now longer liquidate their positions with confidence as they once did, which one day will cause a large problem. The regulation that was supposed to keep banks from taking on too much risk has now concentrated all of that risk into the largest bond funds in the world, and these bond funds can now longer sell their bonds as they once did. Over the last 20 years there has been numerous times the bond markets have gotten spooked and have had massive sell offs (1994 pesos crisis, 1998 Asia crisis,2001 tech blowup, 2008 mortgage meltdown) and each time the crash has been worse and more pronounced.  However when the next downturn in the bond markets come ( and they always come) the banks will no longer play the essential role they use to play of distributing and placing bonds throughout the bond market.

There is another huge problem in the bond market that is killing liquidity that no one wants to talk about, and that is the way bond prices are reported. Given that bond prices are traded over the counter, there is no central exchange that records the prices of bonds. The way bond prices were historically reported, was that the banks would send prices to their clients at the end of the day. Over the years the large bond funds did not like this system and they asked the regulators to come in and force the banks to report all the bond trades to a system called “Trace”.

The result of this was that the bond market became very efficient in knowing what the price of the bonds were, in addition the size of the trades were reported as well. Given all of this information portfolio managers became very confident in knowing where all the bond prices were at a given time. Yet instead of the markets becoming more efficient, the market became less so. Banks use to buy large blocks of bonds and for assuming that risk, they expected to make a profit. But, with full price information in the market, banks are no longer willing to bid on bonds.

For example if bond x’s last price on a trade for 2 million bonds was 99, the portfolio manger would expect to sell his bonds at 99 as well. However a bank would be unlikely to buy the bonds at 99 but rather at 98.5 in that the bank would want to make money as well. The portfolio manager might be willing to sell his bonds at 98.5, but he is unable given that he has to justify to his bosses on why he sold his bonds at 98.5 when every one else was getting 99, so no trades get done.

So given the Volker and the advent of Trace, the bond market is a shell of what it use to be. The liquidity has been sapped, eventually this lack of liquidity will make the next downturn much more vicious than the last one we last experienced.

The general consensus is that more regulation and better information is the key to financial stability but in life we always have to deal with unintended consequence of decisions that are made. I would argue the consequences of these two laws/decisions are going to be bad for all of us. I would argue sometimes less control and less regulation actually help the consumer more and make things more efficient.

 

Steven Clark