Liquidity is critical to a well-functioning financial system as it brings the ability to trade at low cost. However, there are fears it is falling. Stephanie Baxter looks at whether it is cause for concern.
At a glance
- Dispersing risk away from banks could be leading to lower market liquidity
- Tightening of liquidity would have consequences for schemes
- Trade-off between liquidity and market stability may be inevitable
There are concerns that regulation introduced to strengthen banks and protect investors after the financial crisis is giving rise to unintended consequences.
While dispersing risk from the banks to other market participants has made banks stronger, some people argue this has led to a reduction in market liquidity especially in fixed income.
Banks now have much smaller bond inventories to cope with new regulations that require them to hold more capital against their holdings. However, this potentially limits their ability to act as large scale buyers in a crisis.
Given that liquidity is seen as a key ingredient to the proper functioning of markets by delivering efficiencies and price discovery, should we be concerned if it is lower?
These issues were discussed by experts including former Bank of England deputy governor Sir Paul Tucker at the annual Perspectives event held by AQR Asset Management Institute on 27 April.
"Market liquidity is the cost of trading and market liquidity risk is the risk those transaction costs will increase when you need to buy or sell," explained AQR principal and Copenhagen Business School professor of finance Lasse Pedersen.
State Street Global Advisers global chief investment officer Rick Lacaille said: "Banks have pulled back from market making but actually people are trading less frequently and so there is less trading liquidity in the market. There's a potential lack of dynamism in the banks to put capital where it would make most sense."
This reduction in liquidity is demonstrated by lower trading turnover and wider bid-ask spreads whereas before the crisis turnover was very high and bid/ask spreads were very tight.
Stanford Graduate School of Business professor of finance Darrell Duffy explained the impact of major dealers supplying less liquidity to the over-the-counter markets: "Overall market turnover is down: Treasury market turnover is down, as is corporate and municipal bond turnover."
Meanwhile smaller trade sizes are being offered.
"It's fine if you only want small trades and can have access to electronic trading platforms," said Duffy. "Small trades are the norm now, so there may be a delay to doing large trades as they are taking longer."
High cost, low volume
There is also a higher cost and lower volume of securities financing such as repurchase agreements.
While the big banks have been moving away from market making, high frequency trading (HFT) firms, asset managers, bond funds, hedge funds, and electronic trading platforms are playing bigger roles.
If banks are less interested in providing liquidity, then non-banks could bring it to the market but this may only be a partial solution and it is unclear how significant they could become.
Lacaille warns that lower liquidity brings higher cost: "We should expect further regulatory factors to potentially withdraw a little more risk from the bank side. Although that's not to say we won't have a healthy market making system.
"We will get to a new and better equilibrium where return on equity is restored but investors will pay more in terms of transaction costs."
He also said investors need to be very aware that bouts of volatility will cause liquidity to continue to evaporate quite quickly, and that it could happen in areas aside from credit.
"Everyone's looked at credit – but frankly there should be just as much concern about other areas, FX in particular where by our measures the costs of trading have begun to accelerate and the market's response to movements has become substantially more volatile."
There is much debate over how worried we should be about a reduction in liquidity. Do we have to accept there is a trade-off between liquidity and market stability?
Duffie said: "There was too much liquidity prior to 2008. We're getting to a more balanced position now. But we could have more stability even if it comes at a cost to liquidity."
Tightening of liquidity could have a number of consequences for pension funds including greater losses in adverse conditions which would increase uncertainty and volatility in market prices.
Asset managers will need to ensure their fund structures can guard their investor clients against liquidity seizures.
Lacaille said reducing dependence on trading liquidity is very important and has gone up the agenda. "If you depend on something that's not going to exist, particularly for alpha, you've got a problem in running investment strategies. People depend on it particularly where you have leveraged strategies."
A large pension fund manager asked if there is undue concern about liquidity and price discovery in a market where investors typically have long-term horizons?
Lacaille replied: "We don't fetishize liquidity but regard it as very important. We have been unwilling to play the experiment to ask what happens if it's not around. If you can engineer the system where there's not substantial damage by having a degree of liquidity so people can transact, and transaction process gives rise to more efficient prices, then that leads to harmony. Disharmony is where you look for liquidity as an end in itself and there's a spill-over effect that could be damaging."
Pedersen said liquidity risk is both a cost and an opportunity and argued markets are neither perfectly efficient nor inefficient but instead ‘efficiently inefficient'. This is where competition among investors drives markets to be almost efficient, however certain inefficiencies remain such as getting compensation for providing liquidity and taking the associated risk.
Too much vs too little
Some argue there can be a problem by having too much liquidity in the system. Tucker who now chairs the Systemic Risk Council pointed out in a keynote speech that there tends to be too much liquidity in booms and too little liquidity during the busts:
"These are associated with two forms of social costs – by which I mean capitalism is not quite working. All the transactions and deals going on in the private sector are not achieving the degree of efficiency they could."
"During busts we're concerned about withdrawal of financial liquidity, pushing the economy onto a lower path, which is incredibly costly, whereas during the booms there's been too much, which leads to misallocation of resources and over indebtedness. Nearly all effort has gone into looking at the social costs of bust but not into the social costs of boom."
He concluded: "Many people are worried about liquidity of markets but we haven't even dealt with the potential threats to the liquidity of markets."
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