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Capital market activities (repo, market making…): regulatory impacts and future trends - Economic and monetary challenges

Corporate Bonds market review

By Merlin Martin - Director, Financial Markets, DG for Financial Stability, Financial Services and Capital Markets Union, European Commission

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The problem of liquidity, especially in the bond market, is currently one of the most hotly debated issues in financial market policy circles. Claims that market liquidity has declined over the past years call for our close attention: but they need to be considered against the appropriate background, taking account of all factors affecting liquidity since the pre-crisis situation. While there is widespread perception of a reduction in market-making and repo activities compared to the situation in late 2009, the pre-crisis period may have been characterised by unique conditions where risk was to some extent mispriced and where bond trading volumes might have been driven up by considerable speculative pressure. The market making activity of that time and corresponding bond trading volumes in the secondary market might therefore not have been sustainable. Furthermore, liquidity is dependent on cyclical factors (for example monetary policy, risk appetite and banks funding availability) as well as structural factors, including not only post crisis regulation, but also technological developments, changes of banks business models and competitive forces to name a few.

A clear identification of the drivers of and possible bottlenecks to market liquidity is needed before prescribing policy remedies. For example, the notion that increased prudential requirements are a key driver for increased costs for market making and therefore the main factor causing a more fragile liquidity environment commands support, but needs to be definitively proven. Against that, the post-crisis regulation put in place in the EU has sought to strengthen the stability of institutions and their capacity to act as long-term sources of liquidity and market counterparties. Therefore, the picture is complex. The Commission accepts that it is necessary to integrate the need to preserve liquidity as a key consideration when developing the regulatory framework for financial stability.

As a first step, the Capital Markets Union Action Plan, published in September 2015, includes a commitment to undertake a review of EU corporate bond markets by 2017. This evidence-based assessment will seek to understand how various structural and political changes have impacted on the dynamics at play on these markets. It will enable the EC to make a judgment whether regulatory or self-regulatory measures can improve the functioning of these markets, following the profound changes witnessed in recent years. This reflection will also be able to draw on the many views expressed on this issue, in response to the ‘call for evidence’ on the cumulative impact of regulation.