What is liquidity risk? Is it getting worse? How did COVID-19 affect it? What can we do about it?
Will QExit and FRTB exacerbate the problem?
Measuring market liquidity is complex
Assessing liquidity conditions requires measures of immediacy, tightness, depth and resilience as well as indicators of market breadth if comparing liquidity across similar instruments.
• Immediacy: the time it takes to complete a transaction.
• Tightness: bid-offer spread.
• Depth: time taken to execute a large order flow. The ability to absorb risk premium on trading execution. (HFT – High Frequency Trading activity can disguise market depth and quite often “disappears” in volatile or stress environments.)
• Resilience: the period of time required to recover from price fluctuation caused by a sudden shock or to reach a new equilibrium.
• Breadth: refers to the consistency with which liquidity is distributed within asset classes and markets. Such measures are difficult to evaluate.
What is Liquidity Risk?
Liquidity risk can be assessed through a combination of multiple individual factors:
• Market Risk: the risk of losses arising from movements in market prices. The risks subject to market risk capital requirements.
• Asymmetrical risk: in stress environments many “carry” trades tend to be unwound, this tends to be one-way-round risk and results in
market price gaps.
• Funding: reduced flexibility and consistency of funding options for sovereigns, corporates and financial institutions.
• Hedging: the risk of liquidity “air-pockets” reducing the ability of market risk to be effectively hedged.
• Capital Charges: such charges have risen and continue to rise as regulators try and address systematic risk – FRTB (Fundamental
Review of the Trading Book) goes some way to finessing this.
• Economic impact: an event that impacts risk markets or creates a more persistent liquidity “air-pocket” – these types of events have the
potential to create serious dislocation.
A CRITICAL PROBLEM OF LIQUIDITY RISK IS THAT IT TENDS TO ONLY BE REVEALED EX-POST.
Is liquidity diminishing in financial markets?
Structural vs cyclical liquidity risk
Liquidity has always had a cyclical component to it. When markets are rising liquidity tends to be deeper amid higher volumes and a greater number of participants. But when there is a rush for the exit, much of the previously assumed liquidity can prove to be illusory.
However, a far greater problem facing financial markets is the structural decline in market liquidity over the past decade. This diminishing liquidity, at both the instrument and market level, has become a tangible risk in today’s financial markets and is the focus of an increasing array of analysis by central banks, finance ministries and debt management offices.
The cause of diminishing market liquidity
The primary cause of the decline in market liquidity can be attributed to the tidal wave of regulations – Basel III, MiFID II, Dodd-Frank, FRTB – imposed upon financial systems worldwide, both before and since the Global Financial Crisis (“GFC”). These regulations have been aimed at preventing a systemic financial sector crisis. They do so primarily by requiring financial institutions to hold substantially higher levels of capital and to maintain ready access to stable liquidity. The unintended (?) consequence of these policies has been to substantially increase the cost of balance sheet usage for banks and, accordingly, to deplete the pool of risk capital deployed by them in the market thereby reducing their exposure to future shocks.
These changes have contributed to bank dealers being less willing to employ their balance sheets and instead, to prefer simply matching buyers and sellers.
COVID-19: effect on liquidity.
The outbreak of COVID-19, and the resulting liquidity crisis which ensued, was evidence that a “liquidity shock” to the financial system doesn’t have to originate from “inside” the financial system (systematic risk), as it has historically.
A decade ago, the banking system was vulnerable because banks held insufficient risk capital against their obligations. Following the implementation of the aforementioned regulations, this is no longer the case.
However, whilst this shoring up of post GFC balance sheets ensured strong capital and liquidity provision, it failed to prevent a “no-bid” environment in some markets in March, despite some regulators allowing banks to use prudential capital buffers. Many banks were reluctant to dip into these buffers due to fears that the use of these might be viewed as a weakness in their capital position and cause a “run” on deposits in a repeat of GFC-like episodes albeit for different reasons.
It has become clear that banks no longer view themselves as liquidity providers to many markets.
Whilst they are happy to provide an intermediation function, they are disinclined (and actively penalised) to use their balance sheet for discretionary and proprietary trading activity.
When there is a rush for the exit, much of the previously assumed liquidity can prove to be illusory.
In March 2020 we saw a flight by investors from “risky” to non-risky assets. As volatility in assets increased, banks' willingness to intermediate decreased, liquidity mis-matching increased, redemptions in money market funds increased and margin demanded by CCP’s increased dramatically. This “perfect-storm” caused an upsurge in demand for cash and “liquid” high quality liquid assets (HQLA). Many market practitioners, in a rush to meet cash demands, liquidated their more liquid assets or pledged them in repo financing transactions where they could find capacity to do so.
Given the need for cash, spreads demanded for repo market intermediation and use of balance sheet increased dramatically, as might be expected.
Secured market accessibility allows for market participants to raise liquidity to meet margin calls and redemptions without relinquishing ownership of the underlying asset.
Acquiring cash by way of executing repo transactions requires liquidity both in terms of access to counterparties willing to accept security assets as collateral (based on collateral “quality”) and capacity of the counterparty base to do more business, (accessibility).
The repo markets ability (and premium commanded) to satisfy customer demand for either cash or collateral over certain (balance sheet) reporting dates is well documented. The ability to gain access to this liquidity, as was seen in certain cases in March 2020 not so much.
End users, looking to find liquidity for their bond or cash portfolios via repo, faced hard constraints in terms of both availability and willingness of intermediaries to provide balance sheet intermediation for that collateral/cash transformation. Cost associated with these transactions increased dramatically.
Imminent and future challenges to market liquidity
FRTB - Fundamental Review of the Trading Book.
It is estimated that the European banking system will need to add up to 14%/20% of additional Tier 1 capital to their capital buffers in order to comply with FRTB regulation. Such increase in costs is likely to be recovered by increased fees to their customers, thereby reducing/ eradicating returns to those entities that lend cash and securities, or the removal of intermediation services altogether to some customers. RWA allocated for securities financing as a result of these changes will have to rise dramatically to meet current demand.
As RWA requirements increase, so too will bank balance sheet costs.
The increased cost of doing business for banks will invariably affect the cost of, and how much, balance sheet is extended to their clients post implementation- planned for Jan 2023.
QExit
The more dependent markets have become on Central Bank stimulus to justify credit spreads and valuations, the more susceptible they are to CB withdrawal from these policies. Systematic deleveraging can happen very quickly. Volatility can induce VaR (Value at Risk) sensitive investors to be “forced” out of positions as stop losses are triggered, further triggering stop losses elsewhere as volatility increases due to forced position cutting. Volatility induced position cutting becomes self-reinforcing until such time that the asset value decreases to a level that VaR insensitive investors step in and begin to buy those assets.
Volatility is inversely correlated to market depth.
As vol. rises, market depth becomes increasingly impaired, this leads to larger price swings and consequently more volatility; bid-offer spreads widen, margin calls increase, redemptions increase and previously assumed liquidity in financing markets suddenly becomes harder, and significantly, more expensive to come by.
Could reflation worries lead to VaR shock and liquidity risk?
•There is a danger that unprecedented level of liquidity provision have created “asset bubbles” as investors chased yield and leverage increased.
•Inflation is real and isn't going away soon.
•Political tensions over the Ukraine problem may give central bankers pause for thought, but QExit is on the way.
•Central Banks find themselves in a difficult position - very high levels of debt (both public and private) require that rates be kept low to ease their funding.
•Inflation is overshooting targets - a tightening of financial conditions through stimulus withdrawal and higher rates is policy default.
•The key question is; have they overdone it and if they have, how (and when) will they handle the unwind?
•Central Bankers have to be very cognisent of - as per The economist, if rates rise by 100bp, global interest payments will rise from $10tn to $16tn, or from 12% to 15% of global gdp; if they rise by 200bp, to $20tn or 18% global gdp.
•How many "zombie" companies are out there being kept afloat through QE ?
•The jury is out on of whether Central Bankers have delivered the appropriate, too little or too much stimulus to economies globally.
•The undesired effects of this policy on markets are more difficult to argue against however.
•A focus on yield enhancement and speculative investment over credit quality and “safety” has led to well documented surges in assets and valuations. Is there likely to be a re-price?
Mitigating liquidity risk – secured finance.
Banks, by way of making balance sheet available to intermediate transactions, have always been, and continue to be the main source of liquidity provision to secured finance markets.
However, post-GFC, banks have come under increasing regulatory pressure which has increased their cost of capital, and therefore reduced the availability and increase the cost of balance sheet provision.
Basle4/FRTB commitments will increase the cost, and reduce the availability of balance sheet still further.
When volatility increases, as seen in the past, the demand for intermediation capacity increases exponentially and easily outstrips the supply of balance sheet capacity
Market participants are faced with the fact that their need for liquidity and financing costs are going to go up whilst their ability to source liquidity for their financing requirements are going down.
New initiatives, how are financing markets acclimatising
In light of the issues noted above, market participants are increasingly looking at new initiatives through electronification such as peer-to-peer repo and sponsored clearing, both of which promise to increase access to financing liquidity and both of which solve part of the problem but are by no means a panacea.
To date however, there has been no single solution which can solve for:
*Simplified on-boarding allied to cost-efficient implementation
*Electronification of trade flow which is tailor-made per-institution but retains flexibility and usability for both buy-side and sell-side
*Enfranchises its clients by means of reduced costs, increased efficiencies, scalability of legal/technical solution and most importantly, * increases BOTH liquidity AND performance ....until now.....
ConneXXion Markets has been designed to;
Provide our clients with the solution to rapidly expand their secured finance access to new liquidity and opportunity
Help them to meet compliance and regulatory demands whilst also mitigating operational risk
Assist in the legal documentation process, our unique “one-touch” documentation provides for both cost saving and
scalability
“ConneXXion Markets delivers a flexible, secure, execution platform with unique protocols that provide for additional liquidity and performance whilst regulating market function.”
Delivering Digital Performance and Liquidity to Securities Finance - ConneXXionmarkets.com
The views and opinions expressed herein are those of the author and do not necessarily reflect the official position of ConneXXion Markets. They are based upon information the author considers reliable, but should not be taken as investment advice and ConneXXion markets does not warrant the completeness or accuracy of any statements made herein.