U.S. watchdog sees risk of repeated liquidity crunches
WASHINGTON--The U.S. financial system is growing more vulnerable to debilitating shocks as new regulations and market forces change trading habits and reduce the willingness of some market participants to smooth out volatility, a government watchdog warned.
The Office of Financial Research, a new arm of the Treasury Department created by the 2010 Dodd-Frank law, said the system is vulnerable to repeats of what occurred in October, when tumult in the trading of U.S. Treasury securities spread broadly to futures, swaps and options markets.
'Although the dislocation that peaked in mid-October was fleeting, we believe there is a risk of a repeat occurrence,' the office said in its third annual report, adding that such volatility 'raises a host of financial stability concerns.'
The report highlights concerns that have been simmering for more than a year related to a decline in liquidity, or the ability of market participants to buy or sell securities quickly at a given price. The worry is that without enough liquidity, price swings could become more severe across financial markets, raising the cost of credit on Wall Street and Main Street. The report said such swings could be exacerbated by computerized trading and algorithms, as high volumes of transactions automatically execute, deepening instability.
The decline in liquidity is attributed to several factors, including less willingness by large banks to facilitate trading as new regulations make lending cash and securities more expensive. Regulators have said the rules are necessary and will reduce the kinds of excess borrowing that fueled the 2008 financial crisis.
A reduction in securities that are available to lend against in financial markets - such as Treasury bonds and asset-backed securities - is also fueling the volatility. The securitization markets have shrunk since the financial crisis and the Federal Reserve has further reduced the amount of available securities by snapping up trillions of dollars in bonds in recent years.
An expanded version of this story is available at WSJ.com
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