LIQUIDITY, TIME AND COST
The FCA’s analysis did not look at whether the length of time required to conduct trades has increased or whether the price of more urgent trades has increased. Evidence from the industry suggests both have done so.
Bank of England governor Mark Carney, said in late 2014: “The time to liquidate a given position is now seven times as long as in 2008, reflecting much smaller trade sizes in fixed income markets.”
Axa IM is still able to execute 97.4% of trades on the same day, “but it does take a bit longer,” Sanders says.
Matthew James, chief strategist and head of research at CQS, says: “It takes longer and costs more to get in and out of positions today, which is something investors have to factor into their trading strategies, risk management and portfolio decisions.”
Although the extent of those changes varies significantly depending on which part of the credit market a trader is trying to access, one trader says deals that would typically have taken a day or two to execute five years ago might take a week today, while bid-offer spreads have widened materially for some assets.
VOLATILITY
CQS argues that not only has credit market liquidity fallen from pre-crisis levels, but that the market is more volatile because a key counter-cyclical buffer has been withdrawn as ‘The Street’ – the larger banks with market-making operations – are no longer committing capital to be the marginal buyer (or seller) of risk assets.
This ultimately means prices must move further before an opportunistic buyer or seller steps in to stabilise the price of an asset. As a result, the levels by which prices go above or below what the market consensus suggests is fair value will be amplified and more sizeable gap moves will occur, according to CQS. The ‘exit door’ for large positions has become “uncomfortably small”, according to a note issued by the firm in November.
SHOULD LONG-TERM INVESTORS CARE?
Why does any of this matter to a long-term investor who, in theory at least, is a buy-and-hold investor with a greater tolerance for short-term volatility? The failure to adequately measure liquidity means investors are taking unmeasured risk. That could bite hard in the case of a severe liquidity event or where the greater market volatility leads to a series of smaller collective panics that cumulatively erode fund returns over time.
Liquidity risk has become a popular source of returns among investment managers keen to offer solutions to yield-hungry institutional investors given the persistent low interest rate environment. However, in the absence of an adequate measure of liquidity, the models underlying investment processes today rely on assumptions and proxies that introduce a margin of error to measuring an important risk dimension. And the more illiquid the asset, the greater that margin of error can become.
Furthermore, as Sommer and Pasquali point out, many of the factors feeding into liquidity move with each other and can create what they call ‘liquidity spirals’ – negative feedback loops leading to rapidly worsening liquidity and a violent correction in markets.
