Equities are the stars, they are the financial instruments in the headlines. But it is bonds that are the cast and crew. They do the day-to-day work behind the scenes. And, as with any tradable asset, the confidence that prices are fair and that you can sell what you buy is essential.
So, when knowledgeable people express concerns that regulatory changes are causing bond markets to malfunction (see, for example, here), it leads us to ask some tough questions. Are these markets somehow impaired? Is enhanced financial regulation to blame? Is this creating risks to the financial system as a whole?
To anticipate our conclusion, while bond markets are clearly evolving, we do not see reasons for immediate concern about the financial system as a whole. In fact, our expectation is that the capital and liquidity requirements that have made financial intermediaries more resilient to economic downturns and to interest rate spikes, also have improved their ability to stabilize bond markets. That said, we hope that officials will redouble their efforts to collect information and study what is going on in these markets and why.
Turning to the complaints, the loudest and most worrying are about market liquidity. Participants say that it has become more difficult to execute large trades without affecting prices. The claim is that post-crisis regulatory reforms have driven banks out of the business of making these markets, and no one has stepped in to replace them. As a result, there is a shortage of people willing to take the risks that come along with holding the inventories required to readily and continuously buy and sell bonds.
We can separate claims about a loss of bond market liquidity into two fairly distinct categories: those about U.S. Treasury bonds and those regarding corporate bonds. To evaluate these, we start by looking at basic turnover data. What has happened to the value of bonds traded as a fraction of those outstanding in the market?
At first glance, the following chart shows a rise in corporate bond turnover, but a closer look shows that corporate bond volume has always been minuscule – a point that we made in another context in an earlier post. We doubt that the increase in average daily corporate trading volume from 0.5% of dollar quantity outstanding before the crisis to 0.9% today is material. (For a recent discussion of corporate bond market illiquidity, see here.)
Average daily bond turnover as a fraction of the quantity outstanding
In contrast, the decline of turnover in Treasuries is substantial, dropping on an average day from 13.3% of $4¼ trillion outstanding in 2005 to 4.0% of $12½ trillion today. While daily trading volume has lingered in the range of $500 to $550 billion, the quantity outstanding has risen by a factor of three. Considering that the Treasury market is “the deepest and most liquid government securities market in the world,” this pattern merits close scrutiny. And that process is under way.
Focus on the mechanics of the Treasury market surged following the “flash crash” that occurred between 9:33am and 9:45am Eastern U.S. time on 15 October 2014. Having already fallen 18 basis points earlier in the morning, the yield on the 10-year Treasury issue first dropped by an additional 16 basis points for no apparent reason and then quickly recovered, all within a 12-minute interval. By the end of the day, the yield was only 6 basis points below where it had started.
After studying this volatile episode extensively, government authorities recently issued a comprehensive report that includes voluminous and interesting fact-finding about the rapid technological changes in the market. We learn, for example, that the vast bulk of trading in the Treasury market today is done by institutions called “Principal Trading Firms” (PTFs) that use proprietary automated strategies. These PTFs are distinct from hedge funds and bank-dealers. And, unlike traditional market makers, their buy and sell orders are often placed and then cancelled within fractions of a second, making them high-frequency traders. Taken together, PTFs and bank dealers account for nearly 90% of the trading in the cash Treasury market. Put another way, the Treasury market is dominated by trading among big players who by and large put their own money at stake, but who play different roles with respect to other traders.
While there is little evidence that Treasury market liquidity has suffered on average since the financial crisis (see, for example, here), the flash crash report leaves the reader with lingering concern about the functionality of the Treasury market and uncertainty about the potential for systemic risks. Does it matter that the market has shifted from being largely populated by brokers to one inhabited by “bots?” We suspect that dealers are more inclined to make markets during times of stress. In part, this is because they profit – often handsomely – from that activity during normal times, so if the market were to disappear it would influence the viability of their enterprises. And, dealers who are loyal to their customers in times of need hope to be repaid later on. Furthermore, “primary dealers” are obliged to participate in the Fed’s open market operations (both purchases and sales).
By contrast, bots are loyal to the very short-run objectives in their code. They are typically programmed to pull back during times of stress, rather than assist customers who wish to trade. And they trade so rapidly that their algorithmic interactions dominate market developments over short intervals. (See our earlier post about the problems created by high-frequency trading in the stock market and a recent speech by Fed Governor Powell on the specifics of the Treasury market.)
The issue of systemic uncertainty is far more important, but largely unaddressed by the government report. Is there a systemic risk arising from sudden price movements in Treasury (or other) markets that are reversed in a matter of minutes? That is what we really need to know. In the absence of any systemic spillovers, trading is simply a zero-sum game that would be of secondary concern for public policy. (We would still care about issues like trading concentration and front-running.)
Returning to the market for corporate bonds, here the absence of liquidity is chronic rather than abrupt and temporary. While this lowers the potential for systemic risk, it also diminishes wealth: illiquid instruments are worth less to their owners and raise the cost of finance to their issuers. The puzzle is why the issuers and purchasers of corporate debt have had so little apparent incentive over decades to make these bonds more liquid. Importantly, we note that since this illiquidity pre-dates recent reforms, it cannot be attributed to regulatory changes like the Volcker rule, which applies to corporates but not to Treasuries.
The following table taken from a recent BlackRock publication makes the point about the illiquidity of corporate bonds. For a set of U.S. and European investment-grade corporates, the table shows for each issuer: (1) the number of bonds that are included in a popular Barclays bond index; (2) the share of the total dollar amount of bonds outstanding that are accounted for by these included issues; and (3) the total number of bonds overall. For example, JP Morgan has a total of 1,671 separate bond issues, of which only 44 are included in the Barclays index. Yet, those 44 issues account for 57% of JP Morgan’s $380 billion in outstanding debt.
Table 1: Top U.S. and European Investment Grade Bond Issuers
Why would one firm issue so many different bonds of small size when issuing a larger volume of a small number of bonds would enhance their liquidity? We can only speculate. If many of these issues are sold entirely to single buyers – like pension funds and insurance companies – who buy and hold them until maturity, then the benefit of making them more liquid may fall short of the costs of doing so. Note that this is not how the U.S. Treasury manages its liabilities: to ensure that sufficient quantities of its benchmark issues are available for trading, it occasionally re-opens them and adds to the outstanding amount.
That said, we need to know much more about what is going on in these bond markets. In the case of Treasuries, we need to ask whether disruptions like the October 15 flash crash are idiosyncratic or could contaminate other markets. (Recent work by researchers at the OFR is a step in helping us to answer this question.) We care because we know that systemic crises are characterized by a loss of liquidity across a broad range of markets that can result from a specific shock and subsequent contagion.
And, when we look at corporate bonds, we would like to know if there is a simple way to reduce the sheer number of distinct issues and to encourage corporate borrowers, especially the larger ones, to concentrate on a small set of issues that have a chance of being more liquid.
Ultimately, policymakers should focus on the potential for systemic shocks, and leave the issue of chronic illiquidity in individual bond markets to its participants. Can losses from a decline in market liquidity diminish capital in the financial system sufficiently to trigger fire sales and create contagion? If bond turnover has declined because, through the imposition of capital and liquidity requirements, we have removed the public subsidy for market making, then there is little reason to worry. If, on the other hand, liquidity can disappear suddenly and not return, that is a much greater threat. But, with well-capitalized intermediaries that hold sufficient buffers of liquid assets, it’s hard for us to see why a liquidity loss in a single market would not remain temporary and contained.
Our bottom line is this: resilience of intermediaries and resilience of markets are mutually reinforcing. With more resilient institutions, someone is more likely to stand ready to make a market in bonds – both Treasuries and corporates – so long as the rewards are adequate. Since the less liquid a market is, the higher the return to market making will be, the more likely it is that someone will step up to trade when price moves are large. Put another way, better regulation has removed the public subsidy to trading activity that banks and others were able to capture prior to the crisis, so making markets has become more expensive and prices may have to move more than before to attract stabilizing traders. But during those periods when liquidity is particularly valuable, the rewards should exceed these higher capital and liquidity costs.
We worry less, not more, because enhanced capital and liquidity requirements are making intermediaries more resilient.