Risk USA: BlackRock cuts strategies that rely on liquid markets

New liquidity paradigm caused by regulatory constraints is "here to stay", says BlackRock trading chief

Richard Prager and Supurna VedBrat

BlackRock has reined in trading strategies that depend heavily on market liquidity – a response to the risk-taking constraints now facing banks, which have permanently removed liquidity from some products, according to Richard Prager, head of the trading and liquidity strategies group at the asset manager in New York.

"One of the first things we did was to look at investment strategies that were most dependent on liquidity – high-velocity strategies are one example – and we virtually stopped engaging in those strategies that consume a disproportionate amount of liquidity. We have had to modify those investment processes to incorporate the fact that the liquidity paradigm has changed," said Prager, speaking at the Risk USA conference in New York with colleague Supurna VedBrat this morning.

BlackRock now considers liquidity when introducing new products or launching new funds, he added. The firm has also begun to concentrate more of its trading on the liquid points of the interest swap curve, where bid-offer spreads are tighter, in an attempt to reduce transaction costs when putting on or terminating trades, Prager said.

Those measures are part of the firm's response to a retreat from principal risk-taking by big dealers – a phenomenon that first attracted widespread comment during the fixed-income market volatility of late May and June, when hedge funds and other market participants found it more difficult than anticipated to exit positions. Fixed-income products have been hit hardest because their capital requirements have soared as a result of the Basel 2.5 and Basel III regimes, and Prager warned the new environment is not going away.

"There will be less capital coming from the sell side to support traditional market-making activities. Clearly, the fixed-income, currency and commodities principal market is going to be challenged. We are going to see further fragmentation of liquidity, and sadly for our investors, we are going to see increased costs. We don't think that is a cyclical trend. We are not going to wake up and find all this regulation was a bad dream and has gone away – it's here to stay," he said.

We virtually stopped engaging in those strategies that consume a disproportionate amount of liquidity

That explains the firm's support for standardised over-the-counter interest rate swaps, known as market-agreed coupon swaps, which Prager mentioned twice. BlackRock is also campaigning for more standardisation in the corporate bond market, in which some issuers have hundreds of different bonds outstanding, each of which has its own unique identifier – a Cusip in bond market terminology – but which might trade rarely, giving investors a portfolio management headache.

"Corporate bonds are where the market has been seriously challenged. Today, you have a myriad Cusips and for some of the most frequent corporate borrowers the number of bonds outstanding are measured in the thousands. Some major financial institutions might have 30 to 40 Cusips in the Barclays US Aggregate Bond Index, but that same issuer might have in excess of a thousand line items, so there are a lot of orphans out there that just don't trade. Our position is that you need issuers to standardise their issuance, to look at more benchmark issues, and we think the result will be lower issuance costs," Prager argued.

As an example, a research paper published by BlackRock in May found that Bank of America, Citi and JP Morgan had 1,544, 1,965 and 1,645 separate bonds outstanding, respectively.