How resilient is market liquidity?

Market liquidity – the degree to which one can rapidly execute sizable securities transactions at a low cost and with a limited price impact – and its resilience are important for financial stability and real economic activity. Low market liquidity reduces the efficiency with which funds are intermediated from savers to borrowers, and can potentially inhibit economic growth. If market liquidity is low, it is also likely to be fragile, that is, prone to evaporation in response to shocks. And if liquidity drops sharply, prices become less informative and tend to overreact. In extreme conditions, markets can freeze altogether, with systemic repercussions (Brunnermeier and Pedersen 2009). In a recent report, we investigate the drivers behind the level and the resilience of market liquidity with a focus on bonds (IMF 2015a).

In recent years, important transformations in financial markets have had potentially conflicting effects on market liquidity. Banks have been changing their business models, and new regulations may have led them to retrench from market-making activities. The introduction of electronic trading platforms and the growing use of computerised trades may have made market liquidity less predictable. Another key development has been the rising importance of mutual funds.

In addition, unconventional monetary policies are likely to have had contradictory effects, positioning the central bank as a predictably large buyer, while possibly reducing the net supply of certain securities available to investors. Moreover, easy monetary policies have induced a search for yield, prompting funds to invest in bonds with low market liquidity.

The current state of market liquidity

The level of market liquidity has many dimensions – time, cost, and quantity – and cannot be captured by any single measure. We mostly focus on the cost dimension and use imputed round-trip costs (the cost of buying a security and immediately selling it), actual or estimated effective spreads – and Amihud’s (2002) price impact measure.

Compared to historical averages, liquidity is currently high for US and European corporate and sovereign bonds, but there are also signs of a deterioration in some markets. For instance, measures of price impact in European sovereign bonds are now higher than before the 2008 financial crisis. Moreover, US high-yield corporate bonds have become less liquid in recent months and are taking longer to recover from small shocks.

Drivers of liquidity and of its resilience

The drivers of market liquidity levels and resilience comprise three broad categories (Figure 2). These include the risk appetite, funding constraints, and market risks faced by financial intermediaries, all of which affect their inclination to provide liquidity services and correct the mispricing of assets by taking advantage of arbitrage opportunities; search costs, which influence the speed with which buyers and sellers can find each other; and investor characteristics and behavior reflecting different mandates, constraints, and access to information (Vayanos and Wang 2012).

Figure 2. Drivers of liquidity and its resilience

To overcome the inherent difficulty of two-way causality in trying to assess the drivers of market liquidity, we relied largely on event studies to shed light on the role of various factors behind the level and the resilience of market liquidity.

Specifically, we compare bond liquidity before and after specific policy changes, and we measure the change in a security’s liquidity around exogenous market events.

Market making and the level and resilience of liquidity

Surveys suggest that banks are less engaged in market making in fixed income securities, in part because of balance sheet constraints and regulation.

First, we measure corporate bond market liquidity following US Treasury bond auctions, under the assumption that these constrain banks’ balance sheet space – we find that the day after a US Treasury auction, liquidity in the high-yield corporate bond market drops by 13% -- this effect is not visible in the pre-crisis period.

Second, we assess the change in liquidity in individual corporate bonds during the taper tantrum (April-September 2013) – we find that bonds that had one or more dealer quoting it before the taper tantrum on average perform better that the rest by roughly 15%.

We do find evidence that market making matters for liquidity, that dealers’ balance-sheet constraints can impede market making, and that these balance sheet constraints have become tighter in recent years. However, it is not clear whether this is due to regulatory changes or other factors.

Figure 3. Dealers' balance sheet space

Source: TRACE, U.S. Treasury, IMF staff estimations.

Search costs and information asymmetries

Since fixed income markets are, to a large extent, over-the-counter markets, the costs of searching for a counter-party and bilaterally negotiating prices can be substantial (Vayanos and Wang 2008).

Increases in post-trade transparency (which reduce search costs) have indeed improved liquidity;

We measured the effect following the dissemination of trade information by the Financial Industry Regulatory Authority in the US.

We also find that restrictions to derivatives trading (such as the 2012 EU ban on naked sovereign bond credit default swap positions), which increase search costs, lower the liquidity of both the derivative and the underlying asset;Finally, large-scale asset purchases by the Federal Reserve at first improved liquidity of mortgage-backed securities but as the securities became scarcer (and hence, harder to find), reduced it.

Figure 4. Regulation and market liquidity – two examples

Source: TRACE, Markit, IMF staff estimations.

Asset ownership structure and the resilience of liquidity

As banks have been retreating from trading, the ‘buy side’ has become more homogeneous, and funds promising daily liquidity have become more important as holders of bonds, raising questions about potential liquidity risks (IMF 2015b).

Holdings by open-end mutual funds indeed appear to be associated with more fragile liquidity;

Corporate bonds that were owned largely by open-end mutual funds experienced greater declines in liquidity in 2008 and 2013, whereas those owned by insurance and pension funds did not behave differently from the rest.

We also find that bonds where ownership was more concentrated displayed less resilient liquidity.

Figure 5. Ownership and market liquidity

Source: TRACE, IMF staff estimations.

Cyclical factors and the level and resilience of market liquidity

Cyclical factors play a large role in determining the level of market liquidity, and liquidity is prone to switch quickly from high to low levels. Estimations reveal that investors’ risk appetite, funding liquidity, business conditions, and monetary policy are key drivers behind the level of liquidity. Moreover, a Markov-switching model with three liquidity regimes – high, intermediate, and low – suggests that the probability of liquidity being in a low regime is well explained by such cyclical factors.

Figure 6. Main drivers of market liquidity

Source: TRACE, IMF staff estimations.

The findings suggest the following policy recommendations:

Policymakers should adopt preemptive strategies to deal with sudden shifts in market liquidity;Since electronic trading platforms can facilitate the emergence of new market makers, asset managers and other traders should, in principle, have access to these platforms on equal terms;Trade transparency in capital markets and instrument standardization should be promoted to improve market liquidity;Ways to reduce both liquidity mismatches and the first-mover advantage at mutual funds should be considered (IMF 2015b);As the Federal Reserve normalizes its monetary policy, a smooth implementation will be critical to avoid disruptions of market liquidity.

References

Amihud, Y (2002), “Illiquidity and Stock Returns: Cross-Section and Time-Series Effects”, Journal of Financial Markets 5: 31-56.

Brunnermeier, M K and L H Pedersen (2009), “Market Liquidity and Funding Liquidity”, Review of Financial Studies 22(6): 2201-38.

IMF (2015a), “Market Liquidity – Resilient or Fleeting” in Global Financial Stability Report, October.

IMF (2015b), “The Asset Management Industry and Financial Stability” in Global Financial Stability Report, October.

Vayanos, D, and J Wang (2012), “Market Liquidity: Theory and Evidence,” NBER Working Paper 1825.

Authors: Gaston Gelos is the Division Chief of the Global Financial Stability Analysis Division at the IMF. Luis Brandao-Marques is a Senior Economist at the Global Financial Stability Analysis Division at the IMF.