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The financial crisis of 2008 and the subsequent European debt crisis dealt financial markets a serious blow. Investors had to reconsider long-held beliefs that were accepted as truths: that large banks were immune to bankruptcy, and that sovereigns in the developed world would never default on their debt. When the crisis hit and the unimaginable happened, prices of financial assets, apart from a few viewed as safe havens, went into a tailspin.
This is history. Asset prices have rebounded remarkably. Stock markets in Europe as well as the US have reached new historic heights. Corporate debt is in high demand, and risk premia have shrunk noticeably, even for heavily indebted entities. Prices have also increased for more tangible assets such as real estate. Naturally, the continued rise in asset prices is fuelling speculation about potential bubbles. However, judging whether price developments constitute a bubble or reflect fundamental and sustainable factors is not a simple task.
Quantitative easing is designed to work by nudging investors away from safe havens and towards riskier assets. However, one has to realise that the balance to be struck is rather delicate. There is a serious risk that investors will start to underestimate the risks of their investments, leading to price distortions and misallocation of capital. An abundance of liquidity will not by itself make a risky investment less so. Market participants should think very carefully about what will happen once the ample liquidity provision stops.
The regulations involve stricter rules for capital, stricter provisions for risky transactions, and higher administrative burdens. At the Bundesbank, we are fully aware of these strains and the potential drawbacks of regulatory requirements. Liquidity in the bond and repo markets has decreased, also - but not only - because of new regulations.
Moreover, the higher required capital ratios will increase banks' cost of capital while banks' earnings are currently compressed. This is making it difficult for banks to raise further capital, which is why they may respond to regulatory requirements by deleveraging. This, in turn, may well have negative effects on market liquidity.
At the same time, it is evident that well-designed regulatory measures will help make the financial system more stable. The ultimate aim is to make financial markets more resilient and crisis-proof in the future. Higher resilience will restore market and customer confidence in banks. This is intended partly make up for the higher costs of capital and allow banks to attract more customers and funds. In the long run, a stronger capital base can be expected to enhance banks' loan origination capabilities. These are thus positive effects of regulation which need to be recognised.
I am convinced that we need effective and well-targeted regulation. This also means that we need to closely monitor all effects - intended and unintended - and consider making adjustments, if necessary.
But even if targeted adjustments are made to the regulatory framework, I believe one thing can be expected: while other factors currently weighing on market activity are eventually going to fade out, tighter regulatory requirements will definitely stay, and this is the "new normal" market participants will have to adapt to.
Let me now turn to another phenomenon whose role in market liquidity is, in my view, larger than some observers think. For the last fifteen years the investment community has witnessed a transformation in the landscape of exchanges, brokers and investors from a trading process that is based on human decision making into an automated electronic high-speed exchange. High Frequency Trading (HFT) operates in a matter of microseconds.
The Bundesbank conducted a comprehensive empirical study on the significance of HFT in the German capital market and analysed whether or not HFT has had a positive impact on market liquidity.
The results show that HFT with its 40 percent share of trading volume in the DAX and BUND future, does indeed play a very dominant role in market making and in the supply of liquidity in these very important market segments. The observed characteristics of the market behaviour paint a two-sided picture of HFTs' impact in the markets:
In normal trading environments, the findings support the view that many HFTs act as a stable source of liquidity that provides investors a steady opportunity to trade future contracts at very good prices. Market response times to incoming fundamental news are in the millisecond range and bid-ask spreads are for the most part at their minimum.
During times of increased stress in the markets, such as during the anticipated announcement of important macroeconomic data, the empirical findings show a change in HFTs' behaviour. Market-making activity of high-speed algorithms is significantly reduced, sometimes close to zero for short time periods, while at the same time more aggressive and liquidity-demanding HFT trading strategies take over and start to dominate the trading field.
Hence, the ramifications of HFT and the transformation into an automated trading ecosystem indeed change the liquidity conditions in the market. Drawing the right conclusions is not easy - for market participants and regulators alike.