Liquidity, investment banking, and volatility

The story is somewhat repetitive, at least modern history in the field of financial regulation. As we well know, during the Great Depression the Glass-Steagall Banking Act of 1933 was enacted, which, for our purposes, required the separation of commercial banking on the one hand, and investment banking on the other.

Before the financial crash, banking was rather lightly regulated and, although it worked to set capital in motion, with the Great Depression its negative externalities outweighed its virtues. With this crisis, investment banking came to a standstill, since everyone lost confidence in the market (the most basic element of financial markets is trust). Glass-Steagall, the securities laws, and other regulations were necessary to restore confidence in the market.

These reforms separated credit activity from the issuance and trading of securities. Major banks (those belonging to the Federal Reserve system) were required to split their operations. This was quite radical. Think, by way of analogy, of separating the ability to issue prepaid cards, on the one hand, from lending activity on the other; or separating the creation of financial instruments (originators, asset creators, funds, etc.) from their distribution. We understand the comparison is not very rigorous. But what we want to convey is that, for the time, it was truly radical. It was a trade-off between confidence and harming the profitability of financial firms.

By the 1980s, however, the above seemed restrictive. In line with this sentiment, the Gramm-Leach-Bliley Act of 1999 was enacted. This law dismantled the separation between investment, private, and commercial banking. It coincided with a competitive environment, so relaxing control seemed coherent.

Later, after the 2007 crisis, we arrived at the Dodd-Frank Act of 2010. This law introduced several important modifications. One of them was the so-called Volcker Rule. To simplify matters, we can describe it as a more surgical, meticulous, and detailed separation of banking activity. This rule prohibited banks from using their own balance sheet to trade securities, derivatives, futures, options, etc. with sophisticated counterparties (hedge funds or private equity funds).

This last measure significantly restricted what we call liquidity, because in these types of operations banks acted as market makers and counterparties, creating financial products that mitigate certain risks.

It should be borne in mind, in any case, that the Volcker Rule was softened in 2020.

Now, it is clear that since the financial crisis—whether due to risk-taking or regulatory issues—investment banking has retreated from its classic role of buying and selling assets. Not a few have raised alarms about how this has contributed to the deterioration of liquidity.

A lack of liquidity can be just as dangerous as excessive leverage. When portfolios, strategies, or operations introduce leverage through debt or derivatives, the risk of escalation increases when markets face volatility or shocks.

Regulation, therefore, may have reduced liquidity (by restricting banking activity) and, with it, the ease with which agents can buy or sell a security without sharply moving its price. The lower the liquidity, the higher the volatility.

In simple terms, banks would have shifted from offering their balance sheets to absorb the risks of other agents, to acting merely as intermediaries. This means that risk remains encapsulated, controlled, in the hands of those who may not necessarily be able to manage it properly.

A good example is equities, where market prices have risen, but trading volumes have not. The capitalization of the S&P 500 has grown, but the acts of trading shares have decreased (this may also be due to fewer shares being available). Similar issues occur in the bond market.

So, at present banks do indeed play a role in liquidity, but not through their balance sheets. They are now brokers, merely focused on the efficiency of the limited capital they can add to the market. For this, unsurprisingly, they rely on quantitative techniques and high-frequency strategies (algorithms).

Today, speed is more relevant than capital. The paradox of speed, of High Frequency Trading (HFT), is that it may in fact affect liquidity. There is no consensus in the evidence, but there are symptoms. The Flash Crash of 2010 provides an excellent scenario for this controversy. On May 6, 2010, the Dow Jones Industrial Average fell nearly one thousand points—the largest single-day drop in overall market prices in its history—but quickly recovered. According to an SEC-CFTC report, HFT traders did not initiate the collapse, but they did exacerbate the liquidity problem during the free fall. HFT firms continued operating at high levels, collectively representing 50.3% of total exchange volume. Later, during the price recovery, HFTs collectively represented only 36.6% of total volume. HFT traders were censured for allegedly fleeing the market en masse to shield themselves from crisis stress instead of staying to ensure liquidity, which aggravated market volatility. This is consistent with the idea that HFT can exaggerate price reactions and increase stock price volatility, possibly due to model risk.

HFT is efficient, as bid-ask spreads have narrowed to historic magnitudes. The problem is that we are not certain it provides greater liquidity at the moments when it is most needed. Market makers may be overwhelmed in times of stress, resulting in reduced interaction rather than the increase demanded of any market maker.

The question of whether liquidity can pose a systemic risk has been taken seriously by several researchers. At the very least, it is possible to detect risk (systemic or otherwise) in liquidity.

It is true, in any case, that so-called Flash Crashes have not had lasting consequences or severe dislocations. It is also true that regulatory easing has allowed banks to rebuild the stock of certain assets on their balance sheets. But it seems unlikely we will return to the era when banks comfortably dominated liquidity.

When there is depth, liquidity, conditions for trading, and risk appetite, there are always participants to satisfy the supply and demand for assets, while maintaining reasonable prices for all. But when supply and demand become disconnected from liquidity, prices turn volatile