Strict capital rules would heighten a liquidity crisis says CFTC Commissioner

A commissioner for the US derivatives regulator has warned that stricter capital rules on banks will only heighten a liquidity crisis in potential market stress scenarios.

Speaking at the ISDA’s MiFID II/Dodd-Frank conference, Christopher Giancarlo, commissioner for the Commodity Futures Trading Commission (CFTC), stated that strict capital rules on bank’s balance sheets have caused them to pull back from providing liquidity.

“It appears that one effect of regulatory capital constraints has been to reduce the diversity of liquidity in trading markets by hampering inventory-based liquidity while unburdening proprietary, trading-based liquidity,” said Giancarlo.

He stated the recent ‘flash crash’ with the British pound was exasperated by the banks’ inability to use their balance sheets as market “shock absorbers”.

As a result, banks are being replaced by proprietary trading firms that are not subject to the same regulatory capital constraints. Speaking at FIA Expo in Chicago in October, Don Wilson, founder of DRW Trading Group, said his proprietary trading firm had increased its position in the derivatives market as banks continue to retreat as liquidity providers.

Giancarlo warned: “more episodic trading liquidity and sharper volatility has enormous implications for 21st century markets. It raises the prospect that a future market crisis may be exacerbated by the sudden disappearance of trading liquidity.

“I find it disconcerting that, rather than acknowledging and carefully studying the causes of changing market liquidity, US and foreign regulators continue plowing ahead with capital constraining regulations.”

Giancarlo also addressed the increased fragmentation of liquidity in the global swaps market, due to differences over cross-border regulation between the US and Europe.

He called for the CFTC to “revisit its flawed swaps trading rules to better align them to market dynamics, allow US swap intermediaries to fairly compete in world markets and reverse the tide of global market fragmentation.”