Market liquidity constraints require structural fixes
The writer is President and CEO of the Investment Company Institute
While high inflation dominates the headlines, another potentially worrisome development for markets this year has been the deterioration of trading liquidity.
As the US Federal Reserve alluded to in its latest financial stability report in May, liquidity has been declining since late 2021 in US Treasuries as well as S&P 500 index futures and oil. .
Liquidity – measured by the ease with which buyers and sellers can transact – is essential to the smooth functioning of the market for everyday investors and borrowers. Seeing tensions in these multiple markets should raise real concerns.
In fact, the underlying structural weaknesses have been evident for some time. This is particularly the case in wholesale funding markets where historically banks, acting as brokers, have played a key role in providing liquidity.
Tighter regulatory capital regulations enacted in response to the financial crisis are often cited as making it more costly to trade in fixed income intermediation.
This means that dealers devote less of their balance sheet to market making activities. While others, such as trading companies, may have stepped in to provide liquidity, their goals and incentives are different. Now, to add to these structural changes, the Fed is reducing its Treasury holdings and no longer buying bonds.
To their credit, policymakers – both in the US and globally – have identified that there may be fundamental structural issues at play in market making activities. But alleged weaknesses in the money market and open-end mutual funds have also come under scrutiny.
Policymakers have been considering the risk that the money market and open-ended mutual funds will amplify liquidity shocks – whether any advantage to being “first in” in fund redemptions could spur new sales or create hardship to offload assets in times of crisis.
We are therefore seeing a series of proposals aimed at the money market and open-ended mutual funds to increase liquidity buffers and to require measures such as “swing pricing” which aim to pass on part of the redemption costs to sellers in times of crisis.
This is partly due to misinterpretation of evidence from previous stress episodes, particularly the events of March 2020 when the pandemic brought the global economy to a screeching halt. The fact is that the money market and open-end mutual funds were not the cause of the March 2020 liquidity crisis, and their supposed role in amplifying the crisis is unsubstantiated. by data.
Our research shows that the funds’ total net bond sales, particularly treasury bills, have been far lower than policymakers claim. And the timing of daily net bond mutual fund sales does not match the evolution of the Treasury market dislocation at the time. In addition, their low share of Treasury market trading volume indicates little, if any, amplification of stress.
The main lesson to be learned from the experience of March 2020 is this: we must ensure that secondary markets can provide everyone with adequate liquidity when investors need it most.
A menu of promising steps to achieve this has already been drawn up by policy makers. Ideas include:
• Amend the so-called “additional leverage ratio” which stipulates how much capital banks must hold as a percentage of their assets. This ratio should exclude Treasury bills and Federal Reserve deposits. With more capacity on their balance sheets, banks and their concessionary subsidiaries would be better placed to facilitate bond market transactions in times of crisis. This modification worked well temporarily during the Covid-19 crisis;
• Investigate the potential benefits of central trade clearing to reduce financial institutions’ exposure to counterparty risk. It could also expand their balance sheet capacity to facilitate transactions through netting, which allows trades to be cleared with the same counterparty;
• Promote the expansion of “all-to-all” commerce that allows buyers and sellers to interact directly with each other without using a bank as an intermediary. This can ease pressure on dealer balance sheets in times of crisis;
• Assess the impact of regulation on market participants who provide substantial liquidity and perform broker-like activities in the markets.
Moving this agenda forward requires a sustained, multilateral and multisectoral effort, which policymakers should undertake immediately. Even if it is easier to come up with new rules for the money market and open-ended mutual funds, these efforts will not solve the liquidity problem. Improving market structures will.