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 in the market by such institutions. These changes have contributed to bank dealers being less willing to employ their balance sheets and instead, to prefer simply matching buyers and sellers.
The net result of these changes in bank behaviour has been that non-banks (asset managers, pension funds, insurers, investment funds and money market funds) now have a larger share of financial market assets than they did a decade ago.51% (2018) vs 42% (2007) 1
The Dash for cash and the liquidity multiplier; Lessons from March 2020. Speech given by Anil Kashyap, external member of the Financial Policy Committee 17/11/2020
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.
The issue in March 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 fund’s 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 in March, 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 counter-parties willing to accept security assets as collateral (based on collateral “quality”) and capacity of the counter-party 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, not so much...
Evidence suggests that 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, and the cost associated with these transactions increased dramatically.
The following charts are from a paper published by the Bank of England on 17/11/2020
Sources: The Association for Financial Markets in Europe, Bank of England, Bloomberg Finance L.P, FCA, Morningstar, ONS, published accounts and Bank calculations.
The Dash for Cash and the liquidity multiplier; Lessons from March 2020. Speech given by Anil Kashyap, external member of the Financial Policy Committee. 17/11/2020
Mitigating liquidity risk – secured finance.
How Banks have adapted to this environment.
Banks, under increasing regulatory pressure, have optimised their balance sheet usage for repo by eliminating “lazy” trades (those barely meeting internal return hurdles) and seeking efficiencies where they can. Traders are rewarded for optimisation and return on balance sheet employed.
Bank desks are measured by the amount of risk they take and the amount of capital employed to support both this and balance sheet usage.
Sales desks at Banks are also similarly rewarded for transactions which reward “real” performance, not just volume as may have once been the case. Clients who require balance sheet intermediation must adjust to bank internal return requirements (clearly the relationship with clients here is key).
Key clients are given priority based on overall franchise and “wallet” share/profitability; pricing is adjusted accordingly.
Some bank strategies have become obsolete due to this process of optimisation of balance sheet usage, balance sheet has become a valued commodity to be used sparingly. Netting of transactions, where possible, has become the norm.
Banks increasingly seek to intermediate transactions and reduce principal risk and therefore capital costs.
Clearly bank balance sheet costs have increased, and they have been (generally) reduced as a result aforementioned regulatory change primarily designed to reduce systematic risk.
In the meantime, some slack has been taken up by non-bank participants, however, non-bank participants are not set up to intermediate or utilise balance sheet in order to facilitate market function, they are, in general, price takers rather than price makers.
The need to mobilise HQLA is on the rise, whilst intermediary capacity (bank balance sheet) has generally fallen.
The markets continue to grow, whilst capacity continues to be challenged by on-going regulatory reform.
When volatility increases, the demand for intermediation could easily outstrip the supply of capacity available to market users.
How the market is acclimatising and reacting - new initiatives to help additional liquidity.
In light of the issues noted above, certain market participants are seeking to innovative ways to enhance their access to liquidity.
There has been a drive towards increased electronification, of the whole market in terms of pre and post trade to reduce and seek to eliminate any operational risk. Benefits of electronification include, increased transparency, automation of compliance and reporting obligations, reduction of settlement errors and fails and provision of better connectivity and communication between clients and counter-parties.
Sponsored clearing has become useful a tool for some buy-side firms and an alternative fee earner for banks.
Bespoke solutions, products and strategies derived from innovation and market demand are becoming more prevalent – standardisation, scalability, efficiency, and performance propagates impact and usability. **
In the future, we expect to see “wrappers” of liquidity pools via officially recognised block-chain enabled “BASKETS” giving velocity, usability, security, intra-day liquidity, and fungibility.
The public are increasingly embracing technological change in banking, financial transactions and the use of crypto-currencies. Slow acceptance from regulatory authorities of DLT, will likely lead to protracted adoption of such solutions by the “main-stream” market.
Progress, innovation and change are nonetheless inexorable, market participants should be informed and responsive to new developments or risk having to play catchup.
Roberto Verrillo - CEO ConneXXion Markets.
**ConneXXion Markets provides market participants with additional secured finance capacity from non-traditional channels.
We seek to increase your liquidity pool and are additive to your existing secured finance Bank capacity. Notably, we provide benefits which improve performance not just in market stress scenarios.
ConneXXion Markets are at the forefront of innovation and productive solutions.
Additionally, we offer our customers:
Operational efficiencies: electronification of trade flows, processes.
Removal of complexity: simple, cost-effective, scalable “one-touch” documentation and
Futureproof compliance: we help our clients meet current and envisaged regulatory
ConneXXion Markets: leading the way to liquid and accessible secured finance markets #connexxionmarkets.com