Liquidity: The drought continues
Liquidity in the government bond markets has dried up since the global financial crisis of 2008-09. Do these parched markets characterise the new economic norm?
At a glance
• Market liquidity has deteriorated since the global financial crisis of 2008-09.
• Liquidity is measured in different ways.
• Unlocking buy-side bond inventories could help improve bond liquidity.
• Participants need to accept that liquidity is remain lower than before the crisis.
Historically, government bond markets are the most liquid of all capital markets, with the US Treasury market holding pre-eminence. Yet, there is ample evidence that this market’s liquidity has deteriorated since the global financial crisis of 2008-09.
The debate on liquidity revolves around investment banks having to reduce the capital allocated to market-making. As portfolio manager Grant Peterkin at Lombard Odier Investment Managers says: “In the past, you could sell €200m of BTPs [Italian government bonds] to JP Morgan who would take three days to trade that position into the market. They would make some money out of it and the volatility of the bond would not move that much because they had time to trade. Nowadays, they cannot warehouse the risk and have to get rid of the bonds by the end of the day. As a result, the size that you can trade is 10 times smaller and liquidity in the bond markets we estimate is eight times worse than 2005-06.”
Although market-makers’ capital has been reduced, a plethora of new exchanges and peer-to-peer trading platfroms has been developed. However, Paul Brain, head of global fixed income at Newton Investment Management, points out that the latter is more applicable to less liquid markets such as corporates.
The US market is still the most liquid of the government bond markets. Brain says Newton can easily undertake $50m-$75m (€44m-$66m) worth of trades in the US Treasury market without moving the prices by extensive use of electronic exchanges linked to market-makers. In the Gilt market £20-25m would be an easily movable amount to trade.
In the euro-zone the pattern is more mixed. “The German Bund market is one of the largest euro government bond markets but because of the strengths of their fiscal situation, the amount of new issuance is less than countries such as Italy,” says Brain. “The ECB’s QE [quantitative easing] programme is evenly distributed, and that can lead to some distortions in the Bund market, but not the larger Italian market. There are negative yields almost to the nine-year maturity in German Bunds because of the lack of supply and constant demand.”
The other large global bond market is Japan where Brain sees liquidity as poor. “We have been able to buy $15-20m without any problems in the 30-year, but we are a smaller player in the market.” A significant feature post-crash, he says, is that there can be times when liquidity suddenly disappears when there has been an event such as an unexpected Federal Reserve announcement causing a large selling order in a part of the curve. “Liquidity can evaporate very quickly with gapping down of prices,” he says. For government bond investors that means liquidity can disappear just when they need it.
Liquidity can be an elusive concept with multi-dimensional facets. Ilaria Vigano, global head of regulatory and accounting products at Bloomberg, argues that despite its importance, there exists no universally agreed and adopted measure or model that adequately captures cost and time to liquidity in bond markets.
A recent article by Stefano Pasquali and Philip Sommer of Bloomberg’s liquidity research group suggested that there are four key measures of liquidity:
• Width, typically the size of the bid–ask spread, which measures the cost of consuming liquidity immediately, but does not capture the quantity that can be traded at that spread.
• Depth, the quantity of liquidity supplied, measured by the volume offered at the bid–ask spread.
• Immediacy, how quickly a large trade can be accomplished.
• Resilience, how long it takes for the price to return to the pre-trade equilibrium after a large trade consumes liquidity.
The fact that liquidity can be measured in many different ways causes conflicting and misleading signals. “Most of the discussion we have seen on liquidity in the global bonds markets post the crisis has focused on a supposed major deterioration in the less liquid markets such as high yield, emerging market debt and so on. But, I think this is a misperception. The evidence shows that the major deterioration in liquidity has been in the government bond markets,” says Gianluca Minieri, global head of trading at Pioneer Investments.
He argues, that post 2008, there has been a structural change in liquidity driven by the regulatory and legislative changes that broker-dealers have responded to by changing business models.
The larger bulge-bracket firms continue to commit capital but are more cautious about the positions they take and for how long. Smaller firms have shifted towards working client orders on an agency basis rather than making markets, stepping away from principal trading. “We think that the old market-making model is definitely broken and that banks will inevitably become agency brokers,” says Minieri.
The effects can already be seen. As Brain explains, liquidity in government bond markets varies dramatically between ‘on-the-run issues’ and ‘off-the-run’ issues which have been locked away with little free float. “Liquidity tends to be mainly with the on-the-run issues and you can see that with the US Treasury and the UK Gilt markets where the latest issue is where all the liquidity is and the further back you go, the less liquidity. As a result, the dealing size tends to be smaller and the price spreads wider in off-the-run issues.”
Minieri points out that for market-makers, off-the-run issues need to be kept on bank balance sheets for longer. If the costs rise as a result of regulatory changes they become too expensive to hold. As a result, banks’ market-makers reduce their inventory or just stick to holding on-the-run issues.
Minieri says one way liquidity can be improved is by unlocking buy-side bond inventories. This involves an efficient dissemination of pre-trade information between market participants. “Buy-side firms are believed to hold in excess of 90% of bonds inventory in issuance today,” he says. “This means that when we want to buy or sell a bond today very often the main challenge is to find another buy-side firm on the other side and a broker can facilitate the trade between us. The problem that we need to address is therefore not who is going to intermediate the bond but what initiatives can be taken to defrost that significant percentage of bonds inventory currently held by the buy-side.”
Today, Minierei says, there are probably more than 30 new fixed-income trading initiatives being launched, all with the same objective of sourcing liquidity. But while all-to-all platform and buy-side-to-buy-side trading might represent a potential solution, eliminating the sell-side totally cannot be the right answer. “Bond markets need some level of intermediation. Large asset managers do not want to share or disclose their trading intention to their competitors, especially on their larger positions.” How to create a system that gives the right information to the right people at the right time is an issue that still needs to be resolved.
While the discussions on liquidity and possible solutions to alleviating the lack of it are ongoing, is there a systematic risk that all market participants need to be aware of? Minieri says not. “We don’t want to join the choir of people complaining about systematic risks arising from a lack of liquidity. We think there is a structural change in financial markets and we need to adapt and to evolve. We need acknowledge that the amount of liquidity available pre-crisis was excessive. Now, we may be heading towards more normal levels of liquidity. We need to reset our expectations about the way things need to change. We need to accept the new reality”.
It is difficult to argue with his conclusions.