With the Federal Reserve about to bring a period of unpreceded monetary intervention to an end, investors fear that a period of high volatility may be upon us. Up for debate is the role banks will play in providing sufficient liquidity to weather the period of volatility. Reforms that came after the 2008 crisis will certainly affect the role of banks; even more so since a radical transformation of the fixed income markets has taken place.
Banks argue that their privileged position as intermediaries should be maintained in order to facilitate liquidity during periods when volatility is high, however, recent reforms and new regulation facilitated entry to the market for other parties that can provide liquidity. Therefore most of the trading in on-the-run Treasury bonds today is done by non-bank participants.
The market for interest rate swaps also saw changes. Regulation has helped modernize the market and firm pricing is now available in real-time for institutional investors. Furthermore bid-ask spreads are tighter further reducing risk.
The Markets in Financial Instruments Directive II recently adopted in the European Union helps provide impartial access to all fixed-income markets which in turn improves liquidity in the market. The nondiscriminatory access to trading venues required across the EU will help participants in the market to contribute to and benefit from liquidity.
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