FRTB will add to liquidity woes, warns hedge fund CIO

New trading book rules will “make the situation worse, not better” says Napier Park's Dorfman

Jon Dorfman, Napier Park Global Capital

A new regulatory framework for calculating trading book capital will drain more liquidity from already fragile markets, a top hedge fund manager has warned.

The Basel Committee on Banking Supervision's Fundamental review of the trading book (FRTB) "is as ominous as it sounds," said Jon Dorfman, chief investment officer at Napier Park Global Capital, which specialises in credit strategies.

"[The FRTB] is really designed to further increase capital charges for trading businesses. There have been some fairly in-depth studies that have shown this will reduce balance sheet provision by the financial system by another 10% to 30% once it is implemented. It is specifically focussed on the trading and liquidity provision business, and it does not currently exist, so it's going to make the situation worse, not better," he said.

The new trading book rules currently exist in draft form only but are due to be finalised by the end of this year. Four banks participating in the most recent study of its impact found capital levels jumped as much as five-fold.

Dorfman was the keynote speaker at the RiskHedge conference in New York on July 8.

There have been some fairly in-depth studies that have shown this will reduce balance sheet provision by the financial system by another 10% to 30%

The Basel III capital rules, coupled with country-specific financial reforms, such as the Dodd-Frank Act and Volcker Rule in the US, have fundamentally changed the structure of financial markets - limiting the ability of banks to provide liquidity, Dorfman argued. "If you think this liquidity environment is temporary, it isn't. It's a structural, secular change."

Still, some regulators question whether liquidity is really a problem. Last month, Daniel Tarullo, a member of the Board of Governors of the Federal Reserve System, said he did not "see much evidence in spreads of big changes or illiquidity".

Dorfman challenged the Fed governor's stance. "There is a lot of confusion about what liquidity means," he said. "What liquidity means is the ability to buy or sell an asset at its current price. It doesn't mean at any price. The issue is a lot of people confuse that, including regulators."

The new regulatory framework does have its benefits, however. "We will have many less situations like 1998 and 2008 where the banks have been providing liquidity during asset price declines, and then wake up and realise they're the only provider of liquidity, and then sell assets at the bottom of the market and simultaneously constrict lending," Dorfman said. "So actually, I think these rules are really good for the financial system, but I think we have to get used to meaningfully more volatility and much, much more illiquidity."

The downside is that mutual funds, exchange traded funds (ETFs) and money market funds - which own 25% to 30% of corporate bonds outstanding today, compared to 10% a decade ago - should no longer expect to exit positions at reasonable prices at all times, Dorfman said.

"This matters because, unlike insurance companies, pension funds and banks, these are not buy-and-hold-to-maturity investors. They're investors who demand and require liquidity. The vast majority of these mutual funds and ETFs offer daily liquidity. However, there's no market liquidity, so that is a major problem," he said. "I think when we are sitting here 10 years from now, one of the most interesting things that the regulators will focus on - backwards looking, of course - is how could all these funds have been sold to retail [investors], and the people who sold them didn't tell them that the assets couldn't actually be sold anywhere near NAV [net asset value]? So I can see this coming a mile away. It's a real issue."

Investors with longer investment horizons, however, are well placed to capitalise on liquidity driven sell-offs, he added. "Clearly, it's better for asset managers that have longer-dated investment vehicles, because if you're providing liquidity in a market structure where you don't have liquidity, that's bad business."