There have been numerous studies and reports to date that offer valuable insights into the topic of market liquidity. These reports, however, often focus on a particular market or a specific regulation and as such, the aggregate impacts of recent regulations on market liquidity are not well understood. With increasing concerns being voiced on the far-reaching impacts of regulatory developments on market liquidity, including from their bank members, the Global Financial Markets Association (GFMA) and the Institute of International Finance (IIF) commissioned PwC to undertake a broad review of global financial markets liquidity.
PwC’s analysis focused on available data regarding the tightness, immediacy, breadth and depth of liquidity.
Market liquidity is critical
The report synopsis starts by saying, “Market liquidity is critical to effective market functioning. Liquidity in financial markets facilitates the efficient allocation of economic resources through the productive allocation of capital and risk, the accurate generation and dissemination of issuer-specific information, and the effectiveness of monetary policy and financial stability. The current market evidence points to a measurable reduction in financial market liquidity. For instance, European corporate bond trading volumes have declined by up to 45% between 2010 and 2015. Evidence suggests that large trades are becoming more difficult to execute without affecting prices, with market participants breaking up larger trades into smaller tranches. There have been measurable reductions in banks’ trading capacity: banks’ holdings of trading assets have decreased by more than 40% between 2008 and 2015, and dealer inventories of corporate bonds in the US have declined by almost 60% over the same period. This has accompanied a decline in turnover ratios in corporate bond markets, where trading volumes have failed to keep pace with the increase in issuance.”
Study findings and conclusions
PwC’s report highlights the important role and underlying economics of market-making, and the roles played by different market participants which contribute to resilient market functioning, including the vital role of dealer market makers as a source of liquidity.
PwC concluded that policymakers need to act. They suggest that there are grounds for policymakers:
- to review the calibration of reforms to date and the ongoing regulatory agenda, in order to properly understand the effects of regulatory initiatives by asset class
- to consider whether upcoming regulatory initiatives could likely exacerbate the trends in liquidity with no incremental benefits to safety and soundness.
PwC’s detailed analysis found that:
- notwithstanding the benign market environment encouraged by monetary stimulus, a combination of several factors, including banks reducing risk following the introduction of new regulatory frameworks, have contributed to a measurable reduction in financial market liquidity across various asset classes. For instance, according to the report, European corporate bond trading volumes have declined by up to 45% between 2010 and 2015.
- evidence suggests that block trades are becoming more difficult to execute without affecting prices. Banks’ holdings of trading assets have decreased by more than 40% between 2008 and 2015, and dealer inventories of corporate bonds in the US have declined by almost 60% over the same period. This has accompanied a decline in turnover ratios in corporate bond markets, where trading volumes have failed to keep pace with the increase in issuance.
- analysis indicates an early warning that this withdrawal of dealer liquidity to date has not caused measurable economic damage due to quantitative easing programs and extraordinary monetary policy that are reducing liquidity pressures, and because market participants are adapting by trading some instruments less frequently and in smaller sizes. However, following the unwinding of QE or in a stressed environment, liquidity risks and market fragilities are likely to be revealed, potentially resulting in higher volatility in financial markets.
(The full report, including an executive summary, is available here: http://www.pwc.com/gx/en/financial-services/publications/financial-markets-liquidity-study.jhtml)
CTMfile take: Everyone agrees that market liquity in many market has, as Clara Furse, Bank of England, put it, “in some key markets has become more fragile” and that regulatory reforms have impacted or will impact financial market activity. Nevertheless, no group, central bank or trade body seems to know what to do about it. There seems to be no golden bullet to solve the lack of liquidity.