The size of the US debt markets have increased significantly since the Financial Crisis, yet the role of fixed income dealers has actually diminished. The assets held by dealers have declined over the last five years and is not even close to what was seen before the crisis. The assets/equity ratio of dealers has also been falling. Dealers are pulling back on their risk-taking in the largest OTC market. There have been some technology changes which make it easier to transact in the fixed income so some trades can actually be matched across large market participants. Unfortunately, the real story is that no one is committing capital to warehouse risk and help facilitate the process of matching buyers and sellers who do not come to the market at the same time. If there is no dealers to provide immediacy, what is going to happen to the price process?
We know what the answer will be. There will be more price jumps and gaps. Volatility will go up and the integrity of the market will decline because it will be uncertain whether trades can get done immediately or at fair prices. The government wanted broker-dealers, especially those associated with banks, to delever. This was one of the key objectives of Dodd-Frank. Take leverage out of the system. Still, it is the second order effects that are always lurking in the background to cause trouble. There is less dealer leverage, but the size of the debt markets do not reflect less leverage. The deleverage of dealers does not match any deleverage in the economy. So, who is going to help provide liquidity?
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