Liquidity in Liquid Markets

There are a few concepts of liquidity, funding liquidity, which is how easily financial intermediaries can borrow, monetary liquidity, which is linked to monetary aggregates, and market liquidity, which is how easily we can trade a particular asset. By ease, we mean low transaction cost with limited price impact, including depth of market.

There has been concern for some time that regulations may affect the market liquidity in some fixed income markets.

According to Matteo Regesta and Alessandro Tentori in “Market liquidity in liquid markets: Pitfalls and trends”,

Market liquidity is often defined in terms of the smooth and rapid execution of large transactions. However, there is no guarantee that large and frequently trading markets will stay liquid under all circumstances. With the introduction of the EU’s Markets in Financial Instruments Directive 2, known as ‘MiFID2’, time-varying market liquidity is quickly becoming a key feature of large and deep fixed-income markets (such as the market for European government debt). For example, trade transparency rules require the regulator to provide a robust model of bond liquidity. Incorrect liquidity calibration could lead to a large number of ‘false positives’, i.e. illiquid bonds which are defined as liquid.

This matters not only for end investors, but also for market makers who ultimately provide liquidity to markets. Disclosing a transaction in an illiquid security exposes the dealer to liquidity risk in addition to market, credit and operational risks. Hedging liquidity risk is always problematic and often even impossible. The dealer’s rational response might vary from not quoting at all to maximising the bid/ask spread, reducing the trade size or a combination of the above.

Regulations that aim to bring about positive externalities must take into account the reactions of those regulated, and the reactions by themselves may accumulate to incur a much larger social negative externality. Here, the desire for more transparency in the markets reduces liquidity and frustrates any price-finding mechanism present.

It is also of concern that not only the EU markets that may already be in a negative liquidity trend, but the US Treasuries as well. Although the link between liquidity and volatility is still not wholly understood, the resulting phenomenon of illiquidity could be a rise in the volatility of the trading, especially during tail-events.

According to a report by TD analysts Priya Misra and Gennadiy Goldberg on the US Treasuries,

Our findings show that daily changes in 10-year Treasury yields exceeded one standard deviation (σ) 58% of the time so far in 2015—considerably higher than the 49% observed last year (Figure 2). The 58% measure is the highest reading going back to 1975, suggesting that recent volatility in Treasury markets is unprecedented. As if a record number of “choppy” days were not enough, 10-year yield movements also exceeded 3σ in as many as 9% of trading days this year. This is higher than the average of 6% of days since 1975.

And

The issue, as reflected by our sigma measure, may very well be one of “fat tails problems” and lower liquidity during these tail events due to lower dealer risk appetite.

The analysts pointed out that the effects of regulation and change in the market structure could have promoted the extreme moves. If high volatility continues to be a feature of these liquid markets, undesirable behaviour might arise. An expectation of more illiquidity may lead to hoarding, which could in turn self-fulfil in a destructive spiral.

Another important condition for sufficient liquidity is differences in opinions. Policies that are forceful, aligning opinions and making certain aspects ‘a sure bet’ would create an imbalance of supply and demand of the asset, liquid or otherwise.

Liquidity is a positive social externality, an issue that should not be taken for granted. More thinking please.

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