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

The decline of Market-Making in Europe

By Gepp Dennis - Senior Vice President, Managing Director and Chief Investment Officer, Cash, Federated Investors (UK) LLP

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“Unintended Consequences” is a phrase heard many times in recent months in respect of financial market upheaval or a less dramatic change in business practices. So, it is not surprising that the European Commission is taking stock of how the plethora of financial services reforms may have adversely affected the operation of the European Financial Markets.

With a well-intended desire to ensure market stability and minimise the risk of another credit crisis, numerous financial reforms were adopted. Viewed individually, most of the reforms look eminently sensible; however, when viewed as a whole, many are overly burdensome, repetitive and contradictory. While the European markets should focus on growth, participants are struggling with onerous reforms which hamper growth, liquidity and market-making.

Higher levels of capital can protect investors from risk. Certainly direct risks that the capital is designed to bolster will be protected – but if the level of capital required is too high for the organisation that has to raise it, it may be prevented from continuing to provide services and activities needed in the market. And when even the most financially secure market participants say “enough is enough, the risk reward does not justify the capital expenditure” Europe suffers as it will cease to perform such services. If those services include making two way prices in securities, the unintended consequences are a lack of secondary paper for the market to buy or a lack of competitive bids for those wishing to sell.

A lack of secondary paper for the market to buy or a lack of competitive bids for those wishing to sell.

In the repo market the effect of regulation has been dramatic in a different way. Banks are incentivised to hold high quality government securities on reporting days, and are penalised if they repo out those securities to produce cash on those same days. This has the perverse outcome of preventing use of their high quality inventory as a regular source of cash.

There are many unintended consequences that need to be properly evaluated as part of the European Commission’s Call for Evidence. Meanwhile, market participants can only hope that there is not a significant market event that might put severe pressure on liquidity; something that historically would be provided by regulated market makers.