The continued volatility of financial markets has focused attention on the lack of trading liquidity, despite the actions of central banks to maintain a seemingly unlimited supply of money.
There are two types of financial liquidity: the first is funding or the supply of money and the second relates to the ability to buy and sell financial assets readily and without high transaction costs. Central bank policies have simultaneously created an abundance of money and a contraction of trading liquidity.
Trading liquidity is required where holders of securities, commodities and currencies wish to adjust holdings. This may be dictated by the need for cash, for example, when investors in a fund redeem their interest. It might be to alter the composition of portfolios, reduce risk or limit losses.
Only a few stocks, major currencies and some government securities trade consistently and in large volumes. Other assets trade less, particularly where market conditions are unfavorable. Michael Milken, the creator of junk bonds, identified this tendency: “liquidity is an illusion…..It’s always there when you don’t need it, and rarely there when you do”.
Today, trading indicators give the appearance of robust normality. But market turnover, the volume of trading relative to outstanding securities, in bonds and shares has fallen significantly, Government and corporate bond turnover has fallen by around 50 percent, in part reflecting the massive growth in issuance and outstandings.
There are several factors which are driving the problem.
First, central bank policies of low rates and abundant liquidity have driven investors into riskier less liquid assets in search of return. Investors have been forced to invest in longer dated securities, corporate bonds and emerging market issues. In many cases, the issuer is of low, non-investment grade credit quality. They have purchased less actively traded shares or invested in smaller and often less developed equity markets. Investors may not actually recognize that the additional return received does not compensate for the additional risk of reduced trading liquidity.
Second, with markets and prices increasingly driven by changes in official policy, investment horizons have become shorter, making additional claims on market liquidity. Many investors are purchasing assets which they would normally shun, for short term gains on the assumption that they will be divest positions to a ‘greater fool’ before any fall in prices. This game of investment musical chairs relies on anticipating when the tune will stop, which history shows most market participants are poor at.
Third, the nature of investors has changed. It now includes more investment funds, exchange traded funds (“ETFs”) and specialized investors (such as high frequency traders (“HFT”)).
ETFs, which replicate a market benchmark index, are common in equities in both developed and emerging markets, with around US$3 trillion in investments. Currently, bond funds have over US$7 trillion in investments, an increase of US$3 trillion since 2009. Much of the new funds have gone in less liquid securities such as corporate bonds.
Markets are dominated by a few large investors, creating problems of concentration. Similar portfolios and strategies exacerbate risk and the problems of illiquidity if a large number of participants or very large holders wish to exit positions at the same times.
Investors are frequently market following trading the momentum, buying when prices go up and selling when they fall. They are users rather than providers of liquidity. Their buying creates the illusion of active trading when markets are rising but suck liquidity out when prices fall.
Fourth, many Investment vehicles now routinely promise greater liquidity to their investors than that of the underlying investments which they hold. Funds frequently allow investors to redeem their investment at relatively short notice, usually within seven days. The problem is that the fund investments may be insufficiently liquid to allow redemption requests to be met in a timely manner. The IMF found that a fund investing in US high yield corporate bonds might take up to 60 days to liquidate holding, well in excess of the time available to meet investor redemption requests.
Fifth, there has been a sharp contraction in the market making capacity of dealers, particularly in bonds but also in other financial assets. In the US Treasury bond market, major dealers had around US$2.5-3 trillion capacity to make markets in 2007. Today that amount has fallen by over a third. A similar pattern is discernible in Europe. This reduction of dealer capacity coincides with a major expansion in the size of the underlying markets.
The reduction is driven by risk aversion as banks reduce trading activities. The change also reflects regulatory initiatives. Banks have been required to reduce risk, strengthen capital and balance sheets and funding. These measures have made it more expensive and less attractive for banks to make markets for clients. The Volcker Rule embedded in the US Dodd-Frank legislation has restricted banks engaging in proprietary trading, which traditionally has assisted market liquidity and reallocate risk.
The combination of these factors means that trading has become more dependent on a few large institutions and liquidating positions may prove increasingly difficult. Reduced supply and increased demand for market-making will ultimately drive reductions in trading liquidity and higher trading costs which will, in turn, drive higher financing costs and lower investment returns.
The more significant concern is the ability of financial markets to absorb stress. The absence of trading liquidity may not cause the next financial crisis but it will inevitably increase volatility and accentuate losses. The inability of dealers to expand their balance sheets in an elastic manner to purchase cheap assets and warehouse them will, at a minimum, exaggerate price fluctuations. If the shocks are large, then it is not inconceivable that markets will become disorderly or cease to function.
The problems of trading liquidity fundamentally highlight the distorting effects of intervention in market mechanisms. Official policies in the aftermath of the financial crisis have forced excessively risk taking in search of returns to prevent erosion of the purchasing power of savings. At the same, changes in the regulatory architecture have contributed to a reduction in trading liquidity. Over time, the process feeds on itself with investors becoming increasingly exposed to ever more risky financial assets which will become illiquid in a crisis triggering a major collapse in prices.
© 2015 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money