The International Capital Market Association (ICMA) spoke to 47 leading market participants between July and October 2014 about the investment grade corporate bond secondary market. In its report the ICMA points to what it calls the ‘death of liquidity’ as one of the overarching and consistent themes raised in those discussions.
In particular the report highlights the reduction in banks’ willingness to support secondary market liquidity. Those the ICMA spoke to said it had become “almost impossible to get a ready price in larger size”.
The willingness of banks to make markets is critical to the stability of financial markets, however. Ingo Fender and Ulf Lewrick in their March paper Shifting Tides – market liquidity and market-making in fixed income instruments – for the Bank of International Settlements, assert: “In sovereign debt and, to an even greater degree, corporate bond markets, liquidity hinges in large part on whether specialised dealers (“market-makers”) respond to temporary imbalances in supply and demand by stepping in as buyers (or sellers) against trades sought by other market participants.”
Yet, the traditional market-making community has been increasingly squeezed since the financial crisis, significantly reducing their willingness to take on this role. Regulatory changes, including Basel III, EMIR, Dodd Frank and Volker, have weighed heavily on banks’ capital requirements, adding to the costs of them holding inventories of securities in order to make markets – a balance sheet-intensive activity.
LACK OF UNDERSTANDING
The deterioration of liquidity has been highlighted by several recent episodes where volatility has spiked, not least the Taper Tantrum of 2013, but also more recently on 15 October 2014 when the 10-year US Treasury yield “gyrated wildly”, as Lael Brainard, a member of the Board of Governors of the Federal Reserve System, described it, as the intraday movement in prices was six standard deviations above the mean. Similarly, on 18 March this year the US dollar fell 1.75% against the euro in less than three minutes.
Shortly afterwards, the price of German bunds also posted very large intra-day movements during a period of very little market news – although comments made by bond ‘guru’ Bill Gross that the bund was the “short of a lifetime” are oft cited as one spark that lit the flame.
“Many people, including central banks, are still trying to figure out what was behind the recent flash crash in the US or the German bund,” says Florence Barjou, head of multi-asset investments at Lyxor. “They don’t yet have the answers.”
While the contributing factors are likely to be numerous, liquidity played a key part. “It’s hard to say what the cause of the strong market reaction was around the bund,” Barjou says. “Was it that QE has already been successful and inflation is expected to increase which should lead to a normalisation in German rates? Was it a lack of liquidity or market-makers holding less inventory?
“Every time the banks trade,” she continues, “they tend to offload securities again quickly as well due to the capital costs, which adds to the turnover and volatility in the market. These are all valid reasons, but it is difficult to say which is the main cause.”
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