A properly functioning market ecosystem - one that benefits society and investors - is the sum of its parts: retail and institutional customers investing in the future; exchanges cultivating transparent and efficient price discovery processes; and central clearing organisations reducing counterparty risk. In addition, as discussed at the recent WFE Annual Meeting held in Singapore, liquidity and liquidity providers are a vital component of the market ecosystem. Plainly, in order for markets to function properly and serve the public interest, markets need liquidity. Moreover, the markets benefit immeasurably from the presence of professional liquidity providers willing to buy and sell and accept a transfer of risk from investors. Without them and the liquidity they provide, the markets suffer. Unfortunately, there are a number of issues impeding liquidity provision. While there are multiple factors that contribute to these liquidity issues in today’s markets, increasingly, it is regulatory changes that have the most detrimental impact on market liquidity.
Take the bank capital issue in the options markets, for example. Options market makers are professional liquidity providers, and it is these market makers who populate the markets with the bid-ask quotations needed to fill investor orders at good prices. Due to the large quantities of options positions that are held by options market makers, global bank-owned clearing firms tend to be best positioned to financially support clearing an options market maker portfolio. These banks are subject to bank capital requirements imposed by federal bank regulatory agencies. The current exposure method, or CEM, is one particular methodology that is used to compute a bank’s capital requirements and is not able to properly calibrate listed options due to their varied risk profiles. It focuses on the notional value of an option, not the risk it presents. As a result, capital requirements for banks are grossly disproportionate to the actual economic exposure posed by listed options positions. A CEM replacement called the Standardised Approach to Counterparty Credit Risk, or SA-CCR, is on its way, but has yet to be implemented in the EU and the US. It is critical that SA-CCR be implemented in both the EU and the US in order to avoid further liquidity reductions.
Similarly, prudential requirements for investment firms are another example of how regulation can impact liquidity. European authorities recently adopted a new regime that determines capital requirements for investment firms based on a firm’s designation as a systemic (Class 1), non-systemic (Class 2) or small, non-complex (Class 3) investment firm. Prudential requirements have many implications and potential issues. One of which is if the new regulations are not applied in a thoughtful manner, the result will be regulations meant for banks being applied to non-banks, which is what happens when a firm is categorised as a class 1 systemic investment firm. This has negative implications for liquidity as professional liquidity providers offering no banking services would be forced to apply a standard that at times requires them to choose between limiting their trading activity or limiting their hedging activity, which is a critical component of providing liquidity. In short, this is another example of how well-meaning regulations can impact liquidity.
Additionally, under EU regulations, certain EU entities, such as banks, are required to take punitive capital charge if they transact business through a non-qualifying clearinghouse. A non-EU clearinghouse is deemed qualified if it has been recognised by the EU as subject to equivalent regulation. Although European authorities have effectively delayed the implementation of the punitive capital charges, European authorities have yet to recognise important clearinghouses, such as the Options Clearing Corporation, as being subject to equivalent regulations. If the US regime isn’t deemed equivalent it will impede the ability of liquidity providers to clear transactions – this will have a direct impact on liquidity.
Ensuring ample liquidity is essential, and liquidity does not just appear – it needs to be incentivised. This carefully cultivated liquidity allows investors to transfer risk to professional market makers via stable and reliable markets. The best exchanges and clearing firms encourage liquidity provision because they understand the benefits to the ecosystem. Regulations and legal frameworks around the world should be equally focused on liquidity. The solution to regulatory impediments to liquidity provision? Smart and efficient regulation that is applied in a thoughtful way will help reduce hurdles impeding the provision of liquidity, while also ensuring the health of the financial markets ecosystem.