On October 11, 2016, Commodity Futures Trading Commission (CFTC) Commissioner Christopher Giancarlo made an important request to other financial regulators after the October 7, 2016 flash crash in the British Pound. Commission Giancarlo’s request follows his prescient warnings in 2015 that uncoordinated regulations were draining liquidity from U.S. financial markets, as well as his recent podcast reminding regulators and market participants that “21st century markets need 21st century regulation.” Speaking about the October 7th flash crash in Sterling, CFTC Commissioner Giancarlo stated:
“It has been almost two years since I sounded the alarm about heightened market liquidity risk in the global financial system. The increased risk is in part due to untested bank capital constraints imposed by U.S. and overseas bank regulators under the Dodd-Frank Act and similar laws.
Last Friday, the British pound suddenly crashed six percent against the U.S. dollar in volatile trading. The abrupt “flash crash” of the world’s fourth-most-traded currency was exacerbated by a lack of tradeable market liquidity.
There have been at least twelve major flash crashes since the passage of the Dodd-Frank Act. The growing incidence of these events shakes confidence in world financial markets.
We can no longer continue to avoid the question of whether the amount of capital that bank regulators have caused financial institutions to take out of trading markets is at all calibrated to the amount of capital needed to be kept in global markets to support the health and durability of the global financial system.
Today, I repeat my call for a thorough and unbiased analysis by U.S. financial regulators and their overseas counterparts of the systemic risk of unprecedented capital constraining regulations on global financial and risk-transfer markets.”
Flash Crashes and Phantom Liquidity
Reduced liquidity in cash and derivative fixed income markets is due in part to macroeconomic forces beyond increased regulatory scrutiny. But Commissioner Giancarlo is correct. Disparate regulations including Basel III capital requirements, Title VII of the Dodd-Frank Act rules and the Volcker Rule have combined to sap liquidity from even the deepest and most stable markets. The October 15, 2014 U.S. Treasury market flash crash was perhaps the first big warning for market participants. Unfortunately, the October 7th late night Sterling sell-off will not likely be the last fixed income flash crash. With banks stepping back from their traditional role as market makers, non-bank liquidity providers shouldn’t be burdened with regulations that limit their ability to hold inventory or make bids (particularly during times of market stress). U.S. financial regulators can encourage new market participants to step in and act as liquidity providers by eliminating certain elements of proposed Regulation Automated Trading, continuing to refine Swap Execution Facility requirements and better coordinating the cross-border margin rules with non-U.S. regulators. To paraphrase CFTC Commissioner Giancarlo, “21st century liquidity providers need 21st century regulation.”