NEW YORK - As credit freezes up and liquidity all but vanishes, there is an enormous temptation for financial institutions and investors to hold on to their cash and brace for the worst.
Governments around the world last week scrambled to reverse that lack of confidence by injecting trillions of dollars of cash into their banking systems, lowering interest rates and buying up commercial paper, but the more they scrambled, the further stock markets sank, and the more dire the global economic outlook appeared for the months and years ahead.
Thus, last week, at the Investment Company Institute's Equity, Fixed-Income and Derivatives Markets Conference here, regulators and executives focused on how market oversight failed and how to restore liquidity.
"The crucial element, free and liquid trading in the money markets, remains elusive," said ICI President Paul Schott Stevens. "There is no segment of our economy that is insulated from the consequences of the current crisis. We must all work together to unfreeze these markets. I am confident that once the thaw begins, it will advance rapidly."
"There is a total lack of liquidity. Providers are not willing to extend credit," said Lynnette Hotchkiss, executive director of the Municipal Securities Rulemaking Board. "There are only a handful of deals coming to market, and a significant number of deals have been delayed or scaled back."
"We are seeing a dramatic drop in liquidity," concurred Thomas Gira, executive vice president of market regulation for the Financial Industry Regulatory Authority. "We are finding that focusing on the back end really gives us a lot more leeway. We are seeing an increase in erroneous trades, and insider trading is definitely back."
"Instead of being a cop on the beat, regulators hit the snooze button," said Sen. Robert Menendez (D-N.J.), who serves on the Senate Committee on Banking, Housing and Urban Affairs. Menendez said the Securities and Exchange Commission outsourced the determination of risk, choosing to accept the banking industry's own models of what was risky.
"Market discipline failed us," acknowledged Anthony Ryan, acting under secretary for domestic finance at the Department of Treasury. "Our regulatory efforts were compromised. As a result of many excesses, our credit and cash markets have been locked up. When you compromise your ability to function, it chokes growth."
Former SEC Commissioner Paul Atkins ticked off a litany of leniencies: a relaxation of underwriting standards, an increase in off-balance sheet spreadsheets, overleveraged risk and curtailed due diligence by the Office of Thrift Supervision.
There was no one regulator to oversee the failed securities firms' giant holdings companies or their credit default swaps at the broker/dealer level, added Erik Sirri, director of the division of trading and markets at the SEC. In addition, there must be far stricter regulation of credit-rating agencies "for disclosure, conflict of interest and competition," Sirri said.
Joseph Rizzello, CEO of the National Stock Exchange, went so far as to call the $60 trillion outstanding in credit default swaps "weapons of mass destruction" and applauded the Treasury's idea of creating an exchange specifically for CDS.
"With $64 trillion of CES [closed-end second-lien] outstanding, we clearly need some central clearinghouse," Atkins said.
The Treasury is considering creating a market stability regulator with the ability to evaluate capital and liquidity across the entire system (see related story, page one).
Ryan blamed illiquid assets as the root cause of the crisis. Had there been a market stability regulator in place, they would have been able to collect information from banks, broker/dealers and hedge funds and foresee a problem, he said.
"Transparency throughout the process is important," Ryan said. "What happens in financial markets affects people around the world. When people and companies save and borrow, they put their trust in our system."
Many speakers, however, cautioned that more regulations, such as the temporary ban on short selling, may not be the prudent response, particularly when there are plenty of good rules in place that aren't being enforced.
"We need to be careful we don't over-regulate where it doesn't belong," Rizzello said.
"Short selling provides an important equilibrium to the marketplace," said Gary Katz, president and CEO of International Securities Exchange LLC. I think the ban is a bit of an over-reaction. It's naked short selling that creates a problem."
Katz said naked short selling lacks transparency, has no central clearing system and is run by a small group of brokers.
"I support the SEC taking a more draconian approach to short selling," said Richard Ketchum, CEO of NYSE Regulation Inc., but "moving in and out of draconian restrictions may not be the best way to move markets forward. We should have something in place that's regularly used during times of stress, so we can have some predictability in the market."
"All the rule changes have had an impact on liquidity," said Christopher Concannon, executive vice president of transaction services for NASDAQ OMX Group Inc. "We've seen liquidity providers just disappear. People have run from these markets."
Alfred Eskandar, global head of corporate strategy for Liquidnet, said that while normal capital liquidity of banks lending to banks has completely dried up, liquidity in stocks and equities remains, albeit in a smaller form, on ECNs and OTC markets. Liquidnet, for example, pairs large buy and sell orders of a million shares or more for 535 buy-side institutions.
"Technology has allowed tremendous improvements for efficiency," he said. "We can run millions of transactions with great accuracy, in great numbers and at great speed." Last month, Liquidnet had 60 separate trades for a million shares or greater. One such trade was reportedly for 11 million shares.
"Institutions are each other's best source of liquidity," Eskandar said. "Institutions have the ability to become masters of their own domain."
Cost pressure will attract liquidity, and product innovation, combined with consolidation, will allow the opportunity for new markets to pop up, both domestically and globally, said Joe Ratterman, president and CEO of BATS Trading.
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