Monday, February 1, 2016

Liquidity – Fuel for financial markets

The Latin term “liquidum” can have two meanings: Literally, it refers to water or other forms of liquids. In a figurative sense, it means clarity or certainty.

In the financial world today, nothing is certain or clear. Therefore, liquidity must be some form of liquid fueling financial markets. In a recent report on global financial markets liquidity, consultants of Pricewaterhouse Coopers (PwC) have gone into further detail.

What is liquidity?

Liquidity is the ability to execute large transactions with limited price impact. Nice, but when can you actually execute large transactions with only limited price impact?

This is possible when

  • it doesn’t take you a long time to sell. The longer it takes, the more potential sellers will know that you are desperate to sell and, thus, increase the price. This phenomenon is called immediacy and refers to the time it takes you to complete a transaction.
  • you are always able to find someone to buy. This is what experts call market depth and resilience. Basically, the larger the flow of trading orders on both the buy and the sell side, the better it is.
  • you can sell quickly everything you own, be it stocks, debt, certificates, etc.. Finance professionals call this market breadth and, ideally, want liquidity being distributed evenly among asset classes and across markets.
  • it doesn’t cost you a lot to execute trades: The higher the transaction costs the less you will be able to sell without an important price impact. The consultants of PwC talk about tightness and measure this through bid-ask spreads.

Why is liquidity important?

Without liquidity, markets are not efficient. And if markets are not efficient, economic resources cannot be allocated properly, central bankers have a hard time implementing monetary policy, and economic agents cannot manage their risk and funding properly.

Since 2010, liquidity is declining.

PwC gives some examples: The trading volume for European corporate bonds has declined by 45 % since 2010. Banks hold 40 % less trading assets, compared to 2008. Between 2011 and 2015, the market for single name CDS has been cut by half.

Where does this declining trend come from? The PwC experts identify five main reasons:

  • New financial regulation since the crisis penalizes banks holding assets. Very simplified, the need to refinance through equity, everything else being equal, reduces banks’ return on equity. PwC doesn’t tell us whether this is actually good or bad. Their statement is so balanced that, in the end, you don’t really know what their opinion is:
There are grounds for a review of the calibration of the reforms to date and ongoing regulatory agenda, in order to properly understand and consider the effects of regulatory initiatives on market liquidity by asset class, and to consider whether upcoming regulatory initiatives could likely exacerbate the trend in liquidity.”
  • In addition, since the financial crisis, regulators focus more and more on central counter parties replacing parties transacting over the counter to reduce the concentration of counter-party risk. This, coupled with increasing use of electronic trading platforms, might improve the liquidity for standardized instruments. However, it significantly reduces the liquidity for tailor made instruments, namely regarding corporate bonds and infrastructure finance hedging.
  • Today, regulators ask big banks to increase the total loss absorbing capacity (TLAC). This pushes banks to prefer long-term over short-term funding structures and is actually less suited to trading activities.
  • Given the current benign economic environment, volatility in financial markets is too high. The authors of PwC’s report argue that this actually favors a decline in liquidity in financial markets.
  • Market trends don’t favor the liquidity situation: Today, less corporates are issuing bonds and the few who issue do so on a much larger scale. In addition, as banks retreat from commodity markets, market participants become less diverse and bid-ask spreads widen.

The trend of declining liquidity has not been offset yet by increasing electronification and digitalization in financial markets. Obviously, in the long run, the development of electronic trading platforms should favor liquidity because it contributes to lower transaction costs and improved transparency.

What are the repercussions of declining liquidity?

If holding financial assets becomes more expensive, market making become less profitable. If banks practice less market making, fewer people will be there to maintain prices during the next financial crisis. The impact of stress events on prices will then be all the more forceful.

A side aspect of declining liquidity is a phenomenon called bifurcation: This means that liquidity is increasingly concentrating in the most liquid instruments and falling all the more in less liquid assets. This actually disadvantages longer term FX forwards, high yield debt, single name CDS, interest rate derivatives, and mid-cap equities.

After reading PwC’s report, I conclude that liquidity is actually the opposite of what it was supposed to be in ancient Rome. It’s more a source of instability and uncertainty for market participants than a resolving substance.


Global financial markets liquidity study – PwC – August 2015