A dramatic upswing in volatility is putting post-crisis financial markets to the test, as curbs on banks' ability to take risks and an increase in technology-driven trading expose potential new cracks in the system.
While investors and traders say markets have become safer since the 2008 financial crisis - there is less leverage in the system and banks are better able to withstand shocks - they worry that the post-crisis rule book has reduced the market's ability to absorb sharp spikes in buying and selling.
Case in point: last week's sell-off in stocks and lower-rated bonds, which was attributed to a confluence of factors such as disappointing data, fears over global growth and anxiety over the impact of an eventual rise in U.S. interest rates. It was worsened by a lack of banks and market-makers able to step in and buy assets that were being dumped.
These worries were most keenly felt in the corporate bond market, which has been a virtual magnet over the past five years for investors in search of yield at a time of rock-bottom interest rates.
With the Federal Reserve laying the ground for higher rates, making parts of the bond market vulnerable to an investor stampede for the exits, volatile price swings are being exacerbated by the diminished ability of banks to carry securities on their balance sheet for trading.
So while post-crisis rules designed to make future taxpayer-funded bailouts less likely have limited banks' ability to make risky bets on their own account, they have also constrained the basic market-making that can help cushion dramatic price moves.
"Banks and dealers don't have the risk appetite or the ability to commit more capital. ... If everyone tries to get out (sell) at the same time, there could be a bottleneck that develops," said Constantinos Antoniades, head of fixed income at trading platform Liquidnet.
"The volatility that we saw last week, I suspect, was just the tip of the iceberg."
ISSUES MASKED
The problem has been exacerbated by a surge in investor demand for high-yielding assets since 2009.
While banks and brokers' holdings of U.S. corporate debt for market-making has slumped to 0.89 percent of total outstanding assets in 2014 from 2.5 percent in 2004, according to TABB Group data, the market itself has ballooned some 53 percent since 2008, to around $10 trillion.
Asset-management firm BlackRock warned in September that the trading environment for corporate bonds was "broken" and called for a greater variety of trading venues and product types.
"Liquidity has dried up, especially when you're looking at the fixed income market," said Matthew Coupe, director of regulation and market structure at NICE Actimize.
In the U.S. high-yield bond market, daily trading volume averaged $6.9 billion in 2014 through the end of September, up 23.3 percent from last year's pace, according to the Securities Industry and Financial Markets Association.
Meanwhile, junk bond inventory at U.S. primary dealers has averaged just over $7 billion over the last 18 months, New York Federal Reserve data shows, and briefly dropped below $5 billion earlier this summer.
"The major money center banks, which were the major market makers in high-grade and high-yield bonds, now with their new capital rules are no longer supporting bond transactions the way they did in the past," said James Swanson, chief investment strategist at MFS Investment Management in Boston. "So as the market is rising, it works pretty well, but if there is a major influx of sell orders, it is really going to test the market."
Structural issues have also been flagged in other markets, such as equities, where trading is more automated than in bonds and where technology has stepped in to fill the gap left by traditional market-makers.
The rise of high-speed electronic traders and of numerous anonymous trading venues known as "dark pools" - partly due to regulations designed to increase competition among exchanges and lower trading costs - have brought their own problems. Analysts cite a lack of transparency and the fragmentation of trading across several venues that has added to complexity.
"It's not the post-crisis market structure that is triggering these price movements, but on the other hand it can make them worse," said Frederic Ponzo, managing partner at consultancy GreySparks Partners.
NO NOSTALGIA
That does not mean there is nostalgia for the pre-2008 days. Then, banks' market-making capacity was found wanting when big risky bets and a boom in complex debt securities went sour.
Instead, traders say, the emphasis should be on finding ways to better connect buyers and sellers of assets and encouraging other intermediaries to put up more capital despite the risks.
In the bond market, that may mean a drive for more technology, a greater variety of venues and more product standardization, as recommended by BlackRock. In equities, regulators are stepping up scrutiny of market structure and in Europe have proposed capping some dark-pool trading.
For now, though, the sense is that there will be more bumpy rides to come even if the worst of the 2008 crisis is behind us.
"There have been many suggestions and recommendations on how markets should change," said Niall Cameron, HSBC's head of markets for Europe, the Middle East and Africa.
"But I think that market players will have to get used to seeing these short-term, sharp bursts of volatility based on news that ordinarily would not have created so much activity."
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