Vast changes to the regulatory framework designed to ensure the tax payers will not be held responsible for the next big bank bailout are here to say, says a Royal Bank of Scotland Group PLC (NYSE:RBS) (LON:RBS) document. The unintended consequences are a reduction in capital market capacity and overall market liquidity, which may result in more frequent periods of volatility, as has been evidenced in October.

Investors and traders should prepare for further volatility because that is what the U.S. Federal Reserve is doing.

RBS notes Fed expecting market volatility to pick-up

In an article titled, “The System is Safer, But Investors Beware,” the RBS CIO Executive Brief said both “Fed Chair Yellen and New York Fed President Dudley have both recently signaled to the market that they expect market volatility to pick-up as we head towards the first rise in the fed funds rate in nine years.”

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While the RBS report agreed with the Fed generalization, “this is not the only, or even the major reason, why we will see volatility more regularly.” Royal Bank of Scotland Group PLC (NYSE:RBS) (LON:RBS) notes a major cause of forthcoming volatility is reduced liquidity. The problem? You guessed it, increased regulation. “In our mind, the main reason is reduced capital market capacity in the dealer community due to recent regulatory changes,” the report stated.

There is nothing new about shrinking bank balance sheets and reduced leverage ratios, which is the goal of many regulators. However, RBS says the “consequence is clear.” Dealer positions in corporate credit are now miniscule and trading volumes are low, pointing to lowered liquidity. Separately, dealers are reported to be taking less risk, operating more as middlemen in the trade, immediately matching buyers and sellers as opposed to purchasing the credit debt and holding it until a buyer was found, for instance.

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RBS concerned about liquidity in European and U.S. markets

Royal Bank of Scotland Group PLC (NYSE:RBS) (LON:RBS)’ Alberto Gallo, Head of European Macro Credit Research, is so concerned about liquidity in European and U.S. markets, he got creative and developed the RBS “Liquid-o-meter.” Based on Gallo’s measurements, liquidity has fallen nearly 70 percent in global credit markets and 50 percent in U.S. Treasury markets since the 2008 derivatives crisis.

This decline in liquidity comes at a time when retail investors, through mutual funds and ETFs, hold an ever increasing share of the market, near 37 percent, the RBS report said, no doubt sending an intentional chill up the spine of regulators. “Forced selling driven by retail redemptions in times of stress amid reduced volatility has exacerbated market movements,” the report observed, noting that the International Monetary Fund tagged the problem of liquidity mismatching in its April 2014 Global Financial Stability Report.

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As a result, Royal Bank of Scotland Group PLC (NYSE:RBS) (LON:RBS) believes it is more likely investors “will face more frequent periods of volatility, exacerbated by redemptions.” Such moves could be sparked by a number of triggers, from “unexpected policy changes” to “mechanical ETF liquidations stemming from fears of the global economic outlook (October 2014) to just about anything else we can imagine.”

To read the full report click here.