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Financing of the EU economy - Has market volatility increased and liquidity declined?
The changing nature of fixed income market liquidity
By Beau Denis - Director General of Financial Stability and Operations, Banque de France
The financial crisis has profoundly reshaped bond markets which play a crucial role for monetary policy and financial stability. Recent signs point to greater fragility of market liquidity, including on benchmark sovereign bonds, in a context of persistent imbalance between supply and demand of market making services and the rise of algorithmic trading and automated execution strategies.
The market for a financial asset is generally considered to be liquid when it allows the instrument to be bought or sold at any time, for significant amounts and without its price being noticeably or sustainably affected. While price indicators (typically bid-ask spreads) show that liquidity remains abundant, volume indicators point to a deterioration in the average liquidity available, reflected in an increased sensitivity of price changes to the quantities transacted. This is accompanied by liquidity bifurcation on sovereign and corporate bond markets, whereby liquidity tends to be concentrated on specific market segments or securities and scarcer on other segments (e.g. on-the-run vs. off the run securities). Some recent and unpredictable episodes, such as the flash rally on US Treasuries on 14 October 2014 or the Bund tantrum on 7 May 2015, have highlighted that even sovereign bonds, generally considered to be the most liquid, can experience large price swings and a fragile liquidity.
At least three main drivers, some cyclical and others structural, explain these trends. First, a developing gap between supply and demand for liquidity services, as market-makers reduce their supply of immediacy services, while bond issuance and assets under management in open-ended funds are on the rise, increasing the risk that, in case of a shock, large-scale redemptions by investors would trigger fire-sales that the market would find hard to absorb. Second, the development of electronic trading, which is changing the structure of bond markets, traditionally centered on market makers and primary dealers through voice-based and bilateral relations. While it has contributed to reduce transaction costs by enhancing competition, it has also favored the emergence of new players, such as High Frequency Trading firms. These firms may create an illusion of market depth as they are very active in normal conditions but tend to withdraw their orders during periods of high volatility. Third, amongst unconventional monetary policies pursued by central banks, which have largely contributed to bringing liquidity back to satisfactory levels, asset purchases are reducing the float of bonds and thus need to be accompanied by efficient securities lending facilities.
The new environment requires re-thinking from the industry and adaptation from policymakers.
This new market structure and environment requires some re-thinking from the industry and continued vigilance and adaptation from policymakers. Market makers and asset managers should strive to better price and internalize liquidity risk, including by a wider use of liquidity stress testing. Standardization efforts should also be pursued in corporate bond markets, which are lagging behind. Through bank financial reform, authorities have created the conditions for more sustainable supply of immediacy services, by fostering more resilient market intermediaries. They should now proceed to enhance their tools for monitoring market liquidity conditions and for assessing how new liquidity providers and trading platforms are affecting the distribution of risks among market participants. It is also important that bond markets’ access and trading conditions provide a sufficiently rigorous risk framework for high frequency trading firms and electronic platforms, while supporting the diversity of market players and market intermediaries. Finally, central banks should remain vigilant about the impact of their asset purchase policies on market liquidity, and mitigate this impact both ex-ante and ex-post to ensure a continuous and efficient functioning of the markets in which they conduct monetary policy.