With the implementation of the 2010 Dodd-Frank Act being enacted, although not completely written, there have been many negative unintended consequences coming to light. The overarching intent of this Act, specifically the Volcker Rule, was to reduce the scope and limit the amount of risk that Systemically Important Financial Institutions (SIFI’s) could take in not only the capital markets in general, but more explicitly in their proprietary trading accounts. The Act details numerous benchmarks that must be met by the SIFI’s in order to remain compliant with various governing bodies, including a significant increase in capital requirements. Over the past few months, and even weeks as discussed in earlier blogs, the enormous moves in both foreign and domestic bond yields have been nothing short of breath-taking. The reasons for these massive swings may be attributed to the unintended consequences of Dodd-Frank.
Four months ago the U.S. 10yr Bond was yielding 1.60%, today it touched 2.45%... a move of over 50%. The German 10yr Bund was yielding 0.05% a month and a half ago; today it is yielding 0.85%... a 1600% increase in yield. These increases are shown as percentages to illustrate the substantial yield move in such a short time period with no major headline news. The Federal Reserve has not increased the Fed Funds rate as we still have ZIRP (Zero Interest Rate Policy) domestically, and our EU counterpart Mario Draghi, the head of the European Central Bank (ECB) has remained consistent with his implementation of Q€ 1. These shifts were not caused by government intervention, as is usually the case; it is the lack of liquidity that’s causing bid/ask spreads to be greatly widened. Providing liquidity that resulted in tight spreads was a desirable benefit of the SIFI’s proprietary trading activity.
The intent of Dodd-Frank was to increase the capital of the SIFI, which it has done. However, that liquidity transfer from the SIFI’s proprietary trading accounts to their capital accounts is exacerbating the moves in the bond market, widening the bid/ask spreads and resulting in undesirable execution prices for forced buyers and sellers.