The ongoing discussion of market liquidity is just one aspect of the broad, intense and sophisticated lobbying that seeks to roll back much of the still unimplemented post crisis regulation of financial institutions.
Just recently, Andrew Tyrie, chairman of the Treasury Select Committee, made a speech emphasising the need for banks to comply with the will of Parliament and complete the implementation of these regulations. Both the carrot and the stick were evident; memorably: foot-dragging and gaming of the banking “ringfencing” rules could result in their “electrification”. Many saw the defenestration of Daniel Godfrey from the Investment Association and Martin Wheatley from the FCA as further symptoms of the success of this lobbying and resistance to progress and reform.
There can be little doubt that the subject of market liquidity has seized the attention of regulators and supervisors across the world. Last summer, Liberty Street Economics, the NY Fed’s blogsite, published two series of data intensive analyses – one set on US Treasuries, and another set on corporate bonds and other markets. The Bank of England has published “The resilience of financial market liquidity”, and liquidity was a recurrent theme of their recent open forum, which continued the work of the fair and effective markets review.
In all of this analysis, one simple point has been overlooked. If the price of any good is lowered artificially, then the private sector cannot be expected to supply it in any meaningful volume. Quantitative easing has lowered the price of liquidity to unprecedentedly low levels, so we should expect dealers to offer only token amounts. Dealer inventories in US corporate bonds have fallen from a crisis high of $240bn to less than $50bn recently, but annual turnover in corporate bonds is now higher that it was in 2006 and early 2007, at a little above $1.1trn. Simultaneously, the bid offer spreads on both corporate bonds and equities have fallen, as is expected of a measure of the price of liquidity. Competition to trade bonds as agent, and clearly much of the volume today is brokered in this way, should also be expected to pressure dealing spreads lower. Dealer intermediaries have become much more efficient in their use of capital, as is to be expected in a risk based regulatory environment that now emphasises capital sufficiency. Perhaps ironically, if as profitable, that might well justify pay raises and bonuses for all involved.
This new world does have an unintended potential benefit. In an agency world, investment- banking representatives, in their own self interest, should no longer regard investors as ‘muppets’ to be manipulated and exploited for principal gain, but rather as co-operative, trusting and trusted collaborators; a cultural shift that would be most welcome.
When a subject is as nebulous in common usage as liquidity is, there is always room for confusion, misunderstanding and mistake. There is also room for deliberate cherry-picking and selective presentation in support of an argument; the scope is substantial with over eighty different measures of liquidity appearing on one or more academic papers. Derivatives are particularly susceptible. The levels of activity in interest rate swaps are often compared with the turnover of government or corporate bonds. Unfortunately, this is a comparison of chalk and cheese. There is an exchange of liquidity with cash-settled bonds, but not with a fairly-priced interest rate swap. Turnover is a reasonable metric for one dimension of current liquidity in the case of cash-settled bonds but activity in interest rate swaps is a measure of the potential variability of liquidity – they derive their value and cash flows from future changes in interest rates. In other words, turnover in these derivatives is a (partial) measure of the resilience of liquidity over time.
Many derivatives were specifically designed to lower dependence upon current liquidity; the exchange-traded future is a prime example, with its very low initial (cash) margin arrangements. This is an attractive characteristic when we recognise that liquidity is costly. Raising the initial margin or liquidity requirement would be expected to lower volumes outstanding, while increasing the liquidity exchange for any given volume of transactions. Whether this allows us to say anything about systemic liquidity resilience is far more difficult given that there is a buyer for every seller, and central counterparties intermediating. Both equity and fixed interest ETFs have been widely marketed as possessing superior liquidity characteristics, since buyers and sellers net off before any sales or purchases of underlying securities are required. In the marketing jargon, they are “liquidity additive”. The events of August 24 and the subsequent efforts of ETF promoters to right, or at least paper over, price catastrophes should leave no one in doubt over that claim. This problem was graphically described by one bond dealer – “ETF liquidation sales are “sloppy seconds” that I only see when natural demand has been exhausted.”
As we move away from low QE induced rates, and unprecedentedly cheap liquidity, we should expect to see wider bid offer spreads and some increase in dealer inventories, though heavily hedged. Or perhaps, investors will have come to realise that they don’t need immediacy at these prices, and continue their agency activity. Of course, post crisis regulation will affect market liquidity; indeed much was deliberately designed to do so. The judgement being made by the authorities was, and is, that this is worth experiencing as the cost of the greater resilience of our financial institutions for the benefit of all users, not merely those market specialist institutions who are so vocal.
Con Keating is head of research at BrightonRock Group
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