the next crisis : the italian spread , the VIX and the algos

Many pinpoint the cause of such a dramatic dislocation as post-financial crisis regulations which have made it harder for banks to play their historic roleinlubricating bond trading. Higher capital costs have forced them to retreat from being active players, while the embrace of technology and rise of electronic market makers have leftmarketswithless support. “We all know the dealer community’s balance sheets aren’t what they were, and the bids aren’t as deep,” said Jim Caron, a senior portfolio manager at Morgan Stanley Investment Management. “It should absolutely be a systemicworry.” Some argue there is mounting evidence — from a series of sharp sell-offs, such as February’s volatility spike in US equities and now the Italian debt crisis — that the deteriorating health of bond market trading could exacerbate financial turmoil. “I do think that the VIX blow-up and the Italian explosion are reflective of a market structure that is flawed and where we should expect more such events rather than fewer, and that at some point, one will be larger and last longer,” said Peter Tchir, head of macro strategyatAcademySecurities.  Charles Himmelberg, a senior strategist at Goldman Sachs who formerly worked at the New York Federal Reserve, recently caused a stirby saying that “liquidityis the newleverage”. “The rising frequencyof‘flash crashes’ across many major markets may be an important earlywarning sign that something is not quite right with the current stateof tradingliquidity,”he noted. Mr Himmelberg highlighted how bank trading desks had increasingly been replaced by high-frequency traders when it came to supporting two-way market prices, especially in stocks but alsoincreasinglyin bondmarkets. That may make markets seem more efficient most of the time, but when severe shocks happen these algorithmic traders can pull back and add to the dislocations. Another factor has been the presence of central banks as big buyers of government bonds and the unwillingness of policymakers to upset markets. This has helped contain yields at extremely lowlevelsand reducedvolatility. “The long expansion accompanied by relatively low market volatility may have helped disguise an underappreciated rise in market fragility,” Mr Himmelberg warned. “Just as the rapid growth of financial innovation and leverage during the pre-crisis period contributed to the crisis in ways that were not fully anticipated, we will not really know whether markets have in fact become more fragile until after the next downturnor crisis.” Dan Ivascyn, global chief investment officer of Pimco, said that the decline in liquidity usually goes unnoticed but during periods of sharp retrenchment when investors seek to shed riskier assets, it can cause sharp price movements which are “characteristic of markets today”. In the case of Italian bonds, investors are asking how a developedworld fixedincome market buckled so quickly. The unsettling conclusion is that the regulatory inspired changes in the bond market’s ecosystem mean there is little difference between how some government debt trades compared with lower-qualityand riskierassets.