26 June 2017

Why Liquidity-Starved Markets Fear the Worst

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Talk to almost any banker, investor or hedge-fund manager today and one topic is likely to dominate the conversation. It isn’t Greece, or the U.S. economy, or China, let alone the U.K.’s referendum on European Union membership. It is the lack of liquidity in the markets and what this might mean for the world economy—and their businesses. Market veterans say they have never experienced conditions like it. Banks have become so reluctant to make markets that it has become hard to execute large trades even in the vast foreign-exchange and government-bond markets without moving prices, raising fears investors will take unexpectedly large losses when they try to sell.

The U.S. corporate-bond market has almost doubled to $4.5 trillion since the start of the crisis, yet banks today hold just $50 billion of bonds compared with $300 billion precrisis. One major European bank has cut its European government-bond trading book by 75% since 2010 and now quotes daily prices for just 900 corporate bonds compared with 5,000 precrisis, according to a senior trader. Even the giant U.S. Treasury market isn’t immune: Trading volumes have fallen by 10% even as the market has tripled since 2005, while the proportion of outstanding bonds held by dealers has plummeted to 4% from 15% precrisis, according to Deutsche Bank research.

Recent violent swings in European government-bond markets show what can happen when there is a shortage of capital to stabilize markets. In the past month, the German government-bond market has experienced seven of its worst trading days in the past 15 years. This follows similar episodes in U.S. Treasuries and Japanese government-bond markets in 2014 and 2013.

Some investors fear that what has been happening is a dress rehearsal for the mayhem that will happen when a real shock hits, perhaps following a Greek default. It is easy to dismiss this as special pleading but this time the bankers may have a point. There are a number of factors behind this liquidity shortage, not least that banks may be reluctant to hold what they suspect may be wildly overvalued assets.

But a large part of the explanation lies in changes to regulation aimed at addressing weaknesses exposed by the financial crisis. Banks must now hold vastly more capital, particularly against their trading books. The ring-fencing of proprietary trading in the U.S. and retail banking in the U.K. has also squeezed liquidity. Traders fear new EU rules, known as MIFID 2, will make things worse as it will require most fixed-income securities and derivatives to be traded on exchanges, which may make banks even more reluctant to quote prices in illiquid securities.

Some of the resulting liquidity squeeze was clearly intended: Part of the purpose of regulation was to push risks out of the banking system and on to its customers. It is also important to note that worries over secondary-market liquidity hasn’t affected the primary market: Issuance continues to boom, reflecting investors’ frantic search for yield.

The optimistic view is that over time the market will innovate its way around the liquidity squeeze. Perhaps trading will migrate to the futures market and new fixed- income indices, allowing investors to gain exposure to price moves without having to own the underlying asset. Or perhaps new private pools of capital such as hedge funds will take the place of bank-based market makers in providing daily liquidity, although currently they show little appetite to do so. Or maybe longer-term investors such as insurers and pension funds will simply step in and hold less liquid assets to maturity, although this may require a change in the way these businesses are regulated.

An alternative view is that the liquidity squeeze is symptomatic of less benign changes in the financial landscape. In the 30 years since the Big Bang reforms in the City of London and the repeal of the Glass-Steagall Act in the U.S., capital markets have provided the motor for globalization, underpinned by the liquidity provided by banks. If banks stop making markets, the risk is that this process goes into reverse: As investors discover they can’t sell their assets, they may stop buying too, pushing up the cost and reducing the supply of capital to the primary market.

Click here to access the full article on The Wall Street Journal. 

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