Commissioner Daniel Gallagher of the Securities and Exchange Commission (SEC) warned that the illiquidity of the corporate-bond market might cause systemic risk to the economy once the Federal Reserve increases the interest rates.

During his recent speech at the Institute of International Banker’ conference in Washington, Commissioner Gallagher emphasized that the Financial Stability Oversight Council (FSOC) has not paid adequate attention to the corporate-bond market, which is the largest source of capital for companies.

The FSOC was established was created under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Its primary objective is to provide a comprehensive monitoring of the stability of the U.S. financial system.

The council is responsible in identifying risks, promoting market discipline and responding to the emerging risks to the stability of the country’s financial system.

Corporate-Bond Market Could Cause Systemic Risk: Gallagher

Corporate-bond market increased rapidly

Over the past seven years, the size of the corporate bond market increased rapidly to around $7.3 trillion amid low interest rates. Federal Reserve Vice Chairman Stanley Fisher recently indicated that policy makers might raise the interest rates by June or September this year.

According to Commissioner Gallagher, it seems that the staff of the SEC is not paying attention to his warning by planning new rules and initiatives. He emphasized that it is better if money managers and other investors recommend solutions to the SEC.

“It would be a lot better if the SEC could take some action to help the market structure, to create liquidity before we actually have a mess on our hands,” said Commissioner Gallagher.

Last year, the SEC started testing whether fixed-income mutual funds can withstand a potential sell-off in the event of a financial instability, according to people with knowledge about the situation.

The regulator did not release the result of the test to the public, but some of the large money managers already warned that the corporate-bond market might fail when the Federal Reserve starts increasing the interest rates.

Corporate-bond market desperately needs reform

Last year, BlackRock warned that the corporate-bond market desperately needs reform. The firm emphasized that the current “secondary trading environment for corporate bonds is broken.”

According to BlackRock, the problem is concealed by the existing situation of low interest rates and low volatility combined with the positive impact of the quantitative easing (QE) on credit markets.

BlackRock recommended solutions to the corporate-bond market including:

  • More “all to all” trading venues – not just “dealer-to-customer” or “dealer-to dealer”
  • Adoption of multiple electronic trading (e-trading) protocols – not just request for quote (RFQ) or central limit order book (CLOB)
  • Standardization of selected features of newly-issued corporate bonds
  • Behavioral changes by market participants recognizing the fundamentally changed landscape