Jim Rickards On China & Bond Illiquidity

On the bubble in China:



Here is a piece from a full article Rickards wrote this week at the Daily Reckoning on the dangerous lack of liquidity in the bond market. I recommend reading the entire piece, but here was the key section:

According to Mr. Bond, there were many reasons for this (lack of liquidity in bond market). 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.