Market liquidity and financial stability

Everyone seems to be worried about market liquidity – the ability to buy or sell a large quantity of an asset with little or no price impact. Some observers complain that post-crisis financial regulation has reduced market liquidity by forcing traditional market makers – say, in corporate bonds – to withdraw. Others focus on episodes of sudden, unforeseen loss of liquidity – for example, in the equity and Treasury markets – suggesting that structural changes (such as the spread of high-frequency algorithmic trading) are now a source of fragility. We’ve written about these issues before (here and here).

But it is worth taking a step back to ask exactly what it is that we care about. The answer turns out to be complex, so working out remedies will be a big challenge.

Investors cherish liquidity because it enhances the value of their assets. Knowing that they can sell an asset without a large price impact enhances its attractiveness as a store of value. For the most part, this leads to a concern about average market liquidity, which varies greatly across assets even in normal times.

From the perspective of financial stability, however, average market liquidity is not the central issue. What matters is when market liquidity disappears. As we have seen in countless crises, it is the lack of what we would call liquidity resilience that threatens the well-being of intermediaries and the financial system.

But we need to be more precise. There are numerous episodes in which market liquidity is lost temporarily. These include the widely studied equity flash crash of May 2010 and the Treasury flash rally of October 2014. In these two cases, market liquidity seemed to disappear for 36 minutes and 12 minutes, respectively. Such episodes attract interest because of the nagging suspicion that they are caused by some fundamental flaw in the underlying mechanics of the market. The analogy is to “near misses” in transportation, industrial engineering, and healthcare: analysts carefully examine these close calls in an effort to understand how to ensure safety. But in the same way that a near miss for two planes does not by itself harm passengers, such brief episodes of illiquidity (even in a key market like Treasurys) pose no threat to the financial system as a whole.

What counts for the financial system is the unforeseen persistent loss of liquidity. It is in such circumstances that we say that a market has “seized up” or “frozen.” And what matters most is when a freeze affects the financial instruments that intermediaries rely on to meet unexpected demands from bank depositors (or shadow bank investors) who seek cash or borrowers who wish to take down pre-paid lines of credit.

The global financial crisis provides many examples of systemic liquidity freezes. One suffices to make our point. The crisis began in August 2007 with the loss of liquidity in a range of mortgage-backed securities (MBS). The consequence was that asset managers could no longer value these instruments. As the liquidity loss persisted, the crisis deepened and spread across markets, upending a range of intermediaries whose business model depended on their ability to sell MBS without much change in their price. And, as intermediaries failed, fire sales fostered contagion.

The concept of a systemic market freeze helps focus our attention. If we care about preserving financial stability, then we are most concerned with the markets for assets that key intermediaries use to meet unexpected liquidity demands. In the United States today, this is the Treasury market and – to a lesser extent – the market for federal agency debt. No wonder so much attention is paid to the 12-minute flash rally on October 15, 2014.

Yet, the link between market liquidity and financial stability is far more complicated than is likely to be revealed in these intra-day events. One reason is the role of funding liquidity – the ability of an intermediary to borrow at a reasonable cost to fund its holdings of Treasuries, corporate bonds and other (normally) marketable securities. Funding liquidity and market liquidity evolve together: when funding conditions are healthy, dealers find it relatively easy to hold the asset inventories needed to make markets. When funding dries up, market-making can halt as well. Importantly, funding liquidity depends on the perceived well-being of intermediaries. As a result, the level of bank capitalization is closely related both to funding and market liquidity.

Beyond its relationship to funding, there is the possibility that the level of liquidity in various markets in normal times may tell us something about the likelihood of a freeze. The evidence on this question is scant, but it has spawned a raft of recent research from regulators who would like to anticipate the next systemic market freeze in the hopes of mitigating or even preventing it. For example, the IMF’s latest Global Financial Stability Report (GFSR) argues that reduced liquidity in U.S. corporate bonds is associated with increased fragility of that market. And, that fragility in the corporate bond market can spill over to other markets (say, through a loss of funding liquidity). [In contrast, FRBNY researchers find ample market liquidity in corporate bonds and argue that liquidity risk in this market is stable or declining.]

Whatever the specifics, the complex linkages between market liquidity and financial stability influence the potential mechanisms by which losses of liquidity can arise, deepen, and spread. While the greatest damage would come from a freeze in markets for the assets that are most relied on for meeting liquidity demands, the risk of spillovers means that we also need to assess the liquidity fragility of instruments that are traded infrequently even in normal times, like corporates.

Recent research (see here and here) highlights the potential fragility of corporate bond mutual funds. Because of the illiquidity of their assets, investors in these (usually open-ended) funds who exit early benefit if (as usual) the asset manager’s subsequent readjustment of the portfolio imposes illiquidity costs on those that remain. This first-mover advantage creates a risk of a run on corporate bond funds that is analogous to a bank run. Indeed, corporate bond fund flows appear sensitive to past bad news and insensitive to good news. So, with mutual funds now accounting for a larger (and rising) share of corporate bonds held than before the crisis (see chart), the IMF GFSR suggests that this could be a source of increased, and underpriced, liquidity risk.

U.S. mutual fund share of corporate and foreign bonds, 1980-2Q 2015

Source: Federal Reserve Financial Accounts of the United States (Z.1). See also Adrian, et al. Redemption Risk of Bond Mutual Funds and Dealer Positioning (Liberty Street Economics blog).

Source: Federal Reserve Financial Accounts of the United States (Z.1). See also Adrian, et al. Redemption Risk of Bond Mutual Funds and Dealer Positioning (Liberty Street Economics blog).

What to do?

Some observers claim that the best way to ensure financial stability is to safeguard the payments system and leave the vicissitudes of market liquidity and the like for investors to manage. One classic suggestion is to require 100% reserves for deposit-taking banks. Such “narrow banks” are fully insulated from financial disturbances elsewhere. Most important, because they face neither market nor funding illiquidity, there would be no bank runs per se.

However, we seriously doubt that narrow banking would produce the run-free financial system its advocates claim. Suppose, for example, that credit intermediation shifted from banks to mutual-fund-like entities through which, as with most open-end funds today, investors can redeem their investments at any time and receive the daily floating net asset value. Commercial loans (especially to small and medium-sized entities) are even less liquid than corporate bonds, which are typically less liquid than exchange-traded equities. As a consequence, these “credit-supplying funds” would perform the liquidity transformation function that banks previously undertook when they used liquid deposits to fund commercial credit. Unless the funds can price their illiquid assets without lag each day (and without imposing a subsequent portfolio rebalancing cost on their shareholders), the first-mover redemption advantage could still lead to runs and economically disastrous credit freezes. Moreover, the imperative to thwart a depression brought on by the sudden disappearance of credit would undermine the credibility of any government promise not to intervene in this inherently fragile mechanism. As such, while the risk is supposed to be borne by investors, these arrangements lack time consistency: neither fund managers nor fund investors would necessarily price the fragility of liquidity in normal times if they suspect government intervention in an episode of stress. (See our earlier post.)

Another approach to promoting resilience is to reduce the likelihood of liquidity disturbances and – in the event of a shock – to sustain the supply of credit, rather than merely insulating the payments system. This is the approach that leading regulators have taken, using a combination of bank capital and liquidity requirements. The former states the minimum equity as a fraction of assets, while the latter establishes a minimum level of “high quality liquid assets” (HQLA) as a fraction of liabilities. While there is a substantial body of work linking bank capital levels to funding liquidity (and, in turn, to market liquidity), research on liquidity requirements is barely in its infancy (see, for example, here). And, whether a minimum requirement such as the Liquidity Coverage Ratio (LCR) will make market liquidity resilient depends on whether authorities and banks view it as the buffer in times of stress it is intended to be (see here).

But in the end, it is the central bank that provides the most liquid instruments in the financial system – either deposits for banks (reserves) or reverse repos for nonbanks. Supplying these assets elastically is the typical means central banks use to relieve episodes of illiquidity and financial stress. Yet, doing so without limit and without penalty can lead to enormous moral hazard, causing overreliance on the central bank. If market participants are trained to ignore liquidity risk in good times, they will do little to make markets less fragile or to prepare themselves for unanticipated, but persistent episodes of market illiquidity.

So, how do we get everyone to price liquidity risk properly, creating incentives to make market liquidity more resilient? We see this as the biggest open question linking market liquidity and financial stability.

New policy tools could be part of the answer. To see what sort of official intervention might help, consider the liquidity options that the Reserve Bank of Australia (RBA) now sells through its Committed Liquidity Facility so that banks can amass sufficient HQLA to meet their liquidity coverage ratio. From the perspective of the banks, these are “liquidity calls,” as they commit the central bank to providing reserves should the commercial bank ask for them. The RBA currently charges 15 basis points for the option itself, and then the normal lending rate for the reserves should the liquidity call be exercised. By introducing a price in normal times for additions to liquidity in stress periods, these options encourage intermediaries to internalize liquidity risk.

But, it remains to be seen whether the price is right and the incentives sufficient. For example, if there is a market liquidity freeze, will banks use this supplementary central bank liquidity to fund nonbanks who need it most? If the banks are sufficiently well capitalized to expand their balance sheets, perhaps. But there is always the possibility that intermediation will shift to shadow banks that are either less well capitalized, less protected against liquidity shocks, or both. There seems to be no getting around the complex interaction between capital and funding liquidity, on the one hand, and market liquidity on the other.

So, what’s the bottom line? The truth is that we are just beginning to understand the links between market liquidity and financial stability, and how it is that we can ensure essential markets don’t freeze for extended periods of time. It’s good news that a wave of empirical research has started to identify relevant stylized facts. Where the data go, theory is sure to follow. Over time, the biggest challenge will be to keep up with the increasingly rapid changes in market structure that can throw up new, unforeseen threats to liquidity resilience.

Note: We benefited greatly from the two recent series on market liquidity (starting here and here) posted on the Liberty Street Economics blog of the Federal Reserve Bank of New York.