In Part 1 we met my contact “Mr. Bond” – an insider’s insider who regularly speaks to all the major bond market players worldwide.
We also looked at the bond market ‘flash crash’ of October 2014
I told Mr. Bond that this Treasury market flash crash looked a lot like the stock market flash crash of May 6, 2010, when the Dow Jones industrial average index fell 1,000 points, about 9%, in a matter of minutes, only to bounce back by the end of the day.
This kind of sudden, unexpected crash that seems to emerge from nowhere is entirely consistent with the predictions of complexity theory. Increasing market scale correlates with exponentially larger market collapses.
It was important to me to move beyond the theoretical and see whether an active market participant like Mr. Bond agreed. His answer sent a chill down my spine.
How the bond market’s changed
He said, “Jim, it’s worse than you know.”
Mr. Bond continued, saying, “Liquidity in many issues is almost non-existent. We used to be able to move $50 million for a customer in a matter of minutes. Now it can take us days or weeks, depending on the type of securities involved.”
According to Mr. Bond, there were many reasons for this. New Basel III bank capital requirements made it too expensive for banks to hold certain inventories of securities on their books.
The Volcker Rule under Dodd-Frank prohibited certain proprietary trading that was an important adjunct to customer market making and provided some profits to make the customer risks worthwhile.
Fed and Treasury bank examiners were looking critically at highly leveraged positions in repurchase agreements that are customarily used to finance bond inventories.
Taken together, these regulatory changes meant that banks were no longer willing to step up and make two-way customer markets as dealers. Instead, they acted as agents and tried to match buyers and sellers without taking any risk themselves.
This is a much slower and more difficult process and one than can break down completely in times of market distress.
In addition, new automated trading algorithms, similar to the high-frequency trading techniques used in stock markets, were now common in bond markets. This could add to liquidity in normal times, but the liquidity would disappear instantly in times of market stress.
The liquidity was really an illusion, because it would not be there when you needed it. The illusion was quite dangerous to the extent that customers leveraged their own positions in reliance on the illusion. If the customers all wanted to get out of positions at once, there would be no way to do it and markets would go straight down.
The side-effects of central bank stimulus
Another factor that Mr. Bond and I discussed over dinner was the shortage of high-quality collateral for swap and other derivatives transactions.
This was the flip side of money printing by the Fed. When the Fed prints money, the do it by purchasing bonds in the market and crediting the seller with money that comes out of thin air.
This puts money into the system, but it takes the bonds out of circulation. But banks need the bonds to support collateralized transactions in the swap markets.
With so many bonds stuck inside the Fed, there was now a scarcity of good collateral to go around in other markets. This was another type of illiquidity that left markets on the knife-edge of collapse.
As Mr. Bond and I finished our meal and polished off the last of wine, we agreed on a few key points. Markets are subject to instant bouts of illiquidity despite the outward appearance of being liquid. There would be more flash crashes, probably worse that the ones in 2010 and 2014.
Eventually, there would be a flash crash that would not bounce back and would be the beginning of a global contagion and financial panic worse than what the world went through in 2008.
This panic might not happen tomorrow, but then again it could.
The Daily Reckoning