- Denis Beau – Director General for Operations, Banque de France
- Nicoletta Giusto – Director of the International Relations Office, CONSOB
- Greg Medcraft – Chairman, ASIC and Chairman, IOSCO
- Almorò Rubin de Cervin – Head of Unit, DG FISMA, European Commission
- Edwin Schooling Latter – Head of Markets Policy, FCA
- Guy America – Managing Director and Co-Head of Global Credit, Securitized Products and Public Finance, J.P. Morgan
- Nick Forrest – Director, Economics, PwC UK
- Barbara Novick – Vice Chairman, BlackRock
- Stefan Lepp – Head of Global Securities Financing and Member of the Executive Board, Clearstream
Market liquidity requires a “nuanced” assessment
Several indicators show a deterioration of liquidity in Europe particularly in corporate bond markets. Turnover ratios and depths on both sides of the market (bid and ask) are trending down as are dealer inventories. In addition volatility is increasing across asset classes and price impact has spiked quite significantly at the beginning of 2015.
Transaction data however does not show the same concern as impacts have been limited so far for end-users, corporates and investors. Liquidity premia have not moved significantly; bid-ask spreads and round-trip costs have gone down in many parts of the market. Bifurcation is also appearing in the market with some parts of the market losing liquidity while others are performing well. Some panellists moreover suggested that volatility may be driving some of the factors formerly attributed to lower liquidity.
Some speakers suggested that although liquidity problems in EU securities markets do not seem totally established at present, the fact that there is a wide perception of the problem in the market is a sign that they may emerge strongly at a later stage if no specific actions are put in place.
A number of factors can explain the current liquidity trends besides regulation
Understanding why liquidity has decreased and whether this is a structural or a cyclical evolution is essential for determining the appropriate course of action. So far assessments show that the decrease is both structural and cyclical to a certain extent.
Regulatory requirements and notably increased capital requirements for the banks acting as market-makers are taking liquidity out of the market permanently (the less profitable part of liquidity provision), but there are many other positive and negative drivers of market liquidity to be considered.
Technology is an important driver both positive - as it allows a development of electronic trading, a reduction of trading costs and an optimisation of the use of balance sheets – and negative – as it encourages the development of automated trading which may have a negative effect on liquidity in some circumstances, as shown by the recent flash crash / rally in the US Treasuries market.
Other factors to be considered include changes in market structure (e.g. concentration of counterparties, developing role in some markets of mutual funds offering daily redemptions), investment behaviours (e.g. herding, transactions that do not go through the market) and monetary policy (Quantitative Easing reducing the ability to borrow securities in particular). The diversity of the buy-side comprising asset managers (who manage about 25 to 40% of total assets) and asset owners with different types of incentives and liabilities is also important to consider in this context.
Many actions are under way to improve market liquidity
There is no silver bullet to solve the current liquidity issues and a sum of actions is needed with contributions from both the private and public sectors.
The market seems to be adapting fast to the new liquidity conditions. In addition the resilience of the financial sector has improved with the reforms implemented following the financial crisis, which is a good basis for further developing capital markets. However “quick fixes” likely to significantly improve liquidity in the short term seem fairly limited.
An increasing use of electronic trading can be observed as well as a development of trading in smaller tickets. These evolutions are expected to continue with the implementation of MiFID II which favours the emergence of new electronic platforms and increasing disintermediation in the funding of companies. The Market Abuse Regulation should also contribute to developing capital markets in the EU. There is however a strong difference at present across markets and instruments in the adoption of electronic trading.
Service providers are working on solutions to help address the global fragmentation of bond markets and facilitate the mobilisation of bonds, involving the development of partnerships and networks between market infrastructures, global custodians and agent banks. Market infrastructures are also offering additional sources of liquidity e.g. enabling secured interbank money market trading on an anonymous basis against standardised asset baskets.
There are also significant evolutions under way in the asset management sector with changes in the way portfolios are constructed (e.g. with back up sources of temporary liquidity), more resources allocated to liquidity risk management (e.g. with daily liquidity reports, stress testing of adverse redemption scenarios…) and an increasing role of asset managers as “price makers” (i.e. indicating the execution price that they will accept and therefore contributing to price discovery). The introduction of stress testing in the AIFMD and UCITS IV should also lead to a better mitigation of liquidity risks.
Transparency which is due to be enhanced for non-equity instrument transactions in the context of MiFID II is another major area of improvement. Post-trade transparency is considered to be important for liquidity in particular as it may facilitate price discovery and investment decisions. The right choices however need to be made in the determination of instruments subject to the transparency regime in order to preserve existing liquidity, some panellists emphasized. Moreover the impact of primary legislation on secondary market liquidity should also be considered, a speaker suggested, in order to avoid unintended consequences such as were experienced e.g. with the stricter disclosure rules imposed on the issuance of bonds in denominations under €100,000 in the Prospectus directive.
Going further requires a combination of actions from the public and the private sectors
Many actions likely to contribute to improving liquidity were suggested by the panellists. The importance of a close dialogue on these issues between the official sector and the different components of the industry was stressed.
Modernising market structure, particularly in the fixed income market, is a key objective some suggested. This includes further leveraging technology (e.g. electronic trading venues, assessing the potential of blockchain technology) in order to move towards more agency trading, to reduce transaction costs and facilitate the effective use of balance sheets by market participants.
Developing a stronger investor focus (e.g. improving documentation, increasing bond standardisation) and facilitating market access at the global level were also proposed as well as a review of the definition of market-makers in order to impose clearer liquidity provision obligations than at present.
Moreover a suggestion was made to improve investment fund structures which vary at present across regions but which could be further standardised to the best of worldwide practices (e.g. regarding redemption practices, the use of gates or allowing temporary borrowing for short term purposes). Encouraging the development of ETFs which may create an additional source of liquidity was also proposed.
Some however cautioned against the risk of additional regulation disrupting market practices that are already working. The difficulty for market infrastructures to adapt to changing regulation was also stressed. Finally, the importance of assessing market fundamentals and ensuring that risks are appropriately reflected in execution prices was emphasized.
1. Market liquidity is essential for developing capital markets
Speakers on the panel agreed that liquidity is essential to ensure a growth in market based financing and a further diversification of sources of financing (in addition to banks’ balance sheets).Further diversifying the sources of financing of the economy will make the system more stable also since if one type of funding runs into difficulties others can compensate.
Success in building a sustainable European capital market can be measured in many ways, a policy maker stated. One way is to increase the diversification of funding, which does not necessarily mean reducing bank intermediation but increasing the diversity of the sources of funding. Second is further developing a number of markets, such as securitisation and corporate bonds in order to bring more funds into the market. Third, more integration of capital markets is also required in the EU but also more specifically in the Euro area where capital markets would help to reduce imbalances and improve the allocation of capital. Although defining priorities is important, fixing a quantitative objective for the development of capital markets in the EU does not seem necessary.
2. Extent of current market liquidity issues and risks
It is important to assess liquidity risks, a regulator emphasized, as they may have an impact on trading costs and the resilience of financial markets. Signs of liquidity bifurcation have been noted, as is mentioned in a report published one year ago by the BIS, and a significant gap between the perception and the actual measurement of market liquidity is already apparent.
A market observer gave an overview of the current situation of market liquidity1. The measurement of liquidity is not simple. It is necessary to consider "a whole host of indicators" across different asset classes in order to get an appropriate picture of liquidity. The data can be considered in three categories: "good, bad and ugly". In the "bad" category, a number of the trends evident a year ago have continued, for example, a reduction of trading volumes particularly in Europe. In the European corporate bond market, a 45% reduction in trading volumes was observed in the last year alone.
There has been some deterioration in market liquidity according to several indicators, the speaker stated. Turnover ratios (i.e. a ratio of the extent of trading in the secondary market relative to the size of the market e.g. the amount of bonds outstanding) are trending down across both Europe and other regions around the world. Depths on both sides of the market, bid and ask, have also been seen to be diminishing consistently over the last few years. The number of market makers operating in EU bond markets has fallen from eight to seven in the investment grade market, and from seven to four in the high yield market, thus reducing that source of liquidity.
Bifurcation can also be observed, although it is "a tricky issue", the industry speaker added. Certain parts of the market are losing liquidity in some respects. But at the fringes of the markets other parts are performing quite well at the moment and with no significant change.
Whilst there has been a continuation of those negative trends the situation is not "all bad". When looking at the impact of these evolutions on end users, corporates and investors, spreads and liquidity risk premia "have not really moved very much". Spreads are however more appropriate for indicating differences in liquidity across instruments and across asset classes than liquidity trends over time due to other developments, such as "electronification" and a change in the way dealers use their balance sheets.
The liquidity risk premium (i.e. the extra rate of return that investors will demand when any given security cannot be easily converted into cash at the fair market value) is the main factor conditioned by liquidity and that influences the costs to end users and corporates. In an analysis of liquidity risk premia for European fixed income at three levels (i.e. CDS spreads, bond spreads decomposed into liquidity and credit elements), it was found that liquidity risk premia had not really moved over the last few years. Different explanations can be given for this: liquidity may have been sufficient for some time, QE (Quantitative Easing) may be providing sufficient liquidity or there may also be an on-going adjustment process of the industry to a lower level of liquidity. Overall, the impact of liquidity issues on the wider group of users is relatively masked for the time being, the market observer summarized.
Turning to the "uglier" part of this assessment, the speaker emphasized the increase in volatility that has occurred in the last few months. This is evident across asset classes as shown in a recent report: fixed income volatility was up 40%, FX up 100%. This rise is possibly due to cyclical factors or uncertainty about China, the speaker suggested. There has also been an increase of intra-day volatility with big movements in standard deviation and price impact in markets that traditionally moved only by small amounts. Price impact (i.e. how much a security price moves with trading) is a good measure of liquidity. In an analysis of European markets price impact was very low in 2014 but spiked quite significantly at the beginning of 2015 and the trend has continued.
An industry representative referred to a phrase coined several decades ago in the bond market called "bond heaven". Bond heaven was where bonds that never traded again went. This is the situation the market is facing today. There are five key risks in fixed income markets: duration risk, convexity risk, credit risk, foreign exchange risk and liquidity risk. These risks continue to exist even if some of them become more important at certain moments. An infrastructure provider remarked that bonds do not "disappear". Some are now in central bank portfolios (with the QE programme) but most bond issues are simply fragmented across the globe. An industry representative added that a "classic bond heaven" is when bonds are bought by an insurance company. Insurance companies indeed have a long liability and mainly invest in fixed income with a buy-and-hold strategy. Unless they change their evaluation of a particular credit, they are very unlikely to sell those bonds. In this case the bonds will not come out of bond heaven until maturity because the insurer does not want to pay gains or book losses.
A regulator agreed that the assessment of market liquidity has to be "nuanced" and provided some data from the UK market. Regulatory returns from dealers (which indicate precisely how many fixed income debt securities dealers have in their inventories) show quite a significant decline in the inventories compared to a few years ago and this has been sustained over a period. There is also less volatility in the level of inventories which may be explained by less willingness to react to variations in the market. However, the transaction data does not raise the same concerns. It is widely accepted in many parts of the market that bid-ask spreads, which are one measure of liquidity, have narrowed rather than widened. In addition, the price impact of selling bonds has actually declined over the last three year period.
The recent period of volatility may have other explanations, the regulator added. The overall cost of a dealer taking on a security and then offloading it (round-trip cost) is going down not up. An examination of some of the other academic measures of liquidity also shows that the situation is not necessarily getting worse. Turnover charts produced show some downward sloping lines but that is because the comparison is made with the stock of bonds in issue. If the bonds that are in fact trading were examined (i.e. not the ones that are locked up in buy and hold portfolios), there would be no downward trend in turnover, nor a downward trend in transaction size, although the UK market is still very much an OTC market.
Another regulator stressed that the current difference between perception and reality in the measurement of liquidity is an issue. There are underlying forces at play but their impact has not yet been seen in all the asset classes. A weakening of market liquidity resilience can however be observed in some markets both in normal times and stressed periods.
A regulator agreed that the situation is "very nuanced" and that it is unclear whether there is a real liquidity problem in the market or whether it is volatility that is driving many of the factors previously mentioned. There is clearly a change in how the market is operating and this is in part by design. However, even if liquidity problems are not clearly established, the very fact that there is a perception in the market of such problems might be the sign that they might emerge at a later stage.
A regulator was of the view that since the crisis there has been a "huge liquidity bubble" and that liquidity is not much of a problem really. Investors cannot get bonds because there is "so much competition" for pay back
Responding to a comment and example from the floor about the deterioration of liquidity in some markets, a regulator explained that there is no denial of reality by the regulatory community but a nuanced assessment is needed. Improving the situation and ensuring that the resilience of liquidity remains at a good level is possible. In a crisis situation there will be a liquidity freeze, whatever happens, but before reaching that point, there are a number of steps which can be taken to ensure that there is a good resilience of liquidity.
3. Main drivers of the current liquidity trends
A regulator emphasized that a number of analysts and observers have pointed at regulatory change as having an impact on the supply of market-making services in particular, but there are a number of other potential drivers of market liquidity. One of them is technology. There is a positive view about the benefits of the development of electronic trading in reducing costs, but the recent example of the flash crash (or flash rally) of the US Treasuries market demonstrates that it also facilitates the development of certain types of trading, such as algo-trading, that might have a negative bearing on liquidity. Other factors include the development of the bond mutual fund market offering daily redemption to investors, coupled with signs of increasing herding behaviour and concentration among market participants, and possibly the ECB’s large scale purchases of securities related to the QE programme.
Regarding the level of concentration of assets with asset managers, two studies need to be taken into account an industry representative suggested. One study by McKinsey estimated that 75% of global assets are managed in-house, including by large pension plans, sovereign wealth funds and insurance companies. This means that even if there was a huge concentration amongst asset managers, their assets would only represent 25% of the total assets. A second study by the IMF estimates the proportion of funds managed in-house to be 60%, the difference coming from the treatment of some asset classes. Even with the less favourable study, a huge amount of assets is shown to be managed in-house which needs to be factored into any consideration of liquidity, asset allocation and flows.
An industry representative agreed that there are a number of different drivers of market liquidity. The first one is that the pressure on financial institutions to properly account for capital and funding has meant that some of the less profitable liquidity provision that was happening before is no longer possible. There is also technology. It is often mentioned only in the context of the end transaction, but technology is actually used "all across the spectrum" on the buy-side and the sell-side in order to use balance sheets much more efficiently (i.e. knowing where assets are and allowing participants to react more quickly). The way transactions are conducted also affects liquidity measurements. For example, if an investor withdraws money at the same time as another one puts money into the same investment fund they do not have to access the market or if a dealer sells (or buys) directly a position to another client following a transaction without going through the market. Moreover some changes in market structure such as higher concentration e.g. of certain counterparties may also have an impact on the level of liquidity.
The behaviour of market participants is another important factor, the industry representative emphasized. If there is a strong homogeneity of behaviours and "everyone is trying to do the same thing at the same time", the market will not "feel" very liquid. This has probably led to a perception of liquidity being more problematic than is necessarily the case. The addition of Quantitative Easing (QE) to this will have an effect on investment behaviours. QE has for example had an impact on the attractiveness of lending securities, reducing the ability to borrow securities.
A regulator agreed that monetary policy plays "a big role", but the impacts are still unclear. It will be a matter of waiting to see how the situation develops and deciding what are the most appropriate indicators, which is quite difficult to do in real time.
Understanding why liquidity has decreased and whether this is a cyclical or structural decrease is also important before deciding whether regulatory changes are needed or whether this is "just a problem of the market", a regulator believed. There is an on-going study of global bond markets in order to clarify these issues. The decrease is probably both cyclical and structural the regulator considered. Capital requirements are "obviously" taking a great deal of liquidity out permanently but on the other hand there are also cyclical elements. In addition the fact that banks are trying to build sustainable liquidity may become a problem in itself because they may actually take bonds away from investors in doing so. Such issues are being closely looked at by the International Organisation of Securities Commissions (IOSCO) whose fundamental objective is to allow markets to operate and enable investors and issuers to have trust and confidence.
4. Solutions proposed to improve market liquidity
Speakers generally agreed that there is "no silver bullet" to solve market liquidity issues. A sum of different actions is needed and contributions can be brought both by the private and the public sectors.
An industry representative emphasized4 that while there were multiple solutions to the current liquidity issues none of them would be a quick fix. They all had a role to play and need to be developed, but it will take some time to increase the current level of bond standardisation2 or to further increase the role of electronic platforms for example. The question of how to accelerate these solutions arises, because at the present rate of progress it is going to take quite a while.
Many actions are under way to improve liquidity
Electronic platforms and services developed by infrastructure providers
The speed at which the market is already adapting to the "new reality" of liquidity is striking a regulator believed. The way trading is performed in bond markets is changing with the increasing use of electronic platforms and trading in smaller tickets. Although there is still a strong difference e.g. with FX markets, the gap is being reduced quite significantly. The collective challenge is to reduce the unintended consequences of these evolutions and for regulators there is also an important role to play in this perspective.
Electronic platforms are due to play an increasing role another regulator agreed. The regulatory changes in the field of trading related to MiFID in particular are going to reshape the landscape and favour the emergence of new electronic platforms. There are also new forms of disintermediation developing such as crowd funding, which market participants are looking for both for financing and capital raising. The speaker considered that the feasibility of trading non-equity instruments (e.g. Treasury bonds as well as corporate bonds) on electronic platforms is not really an issue. Government bonds have been traded on electronic platforms in Italy for example since 1987.
The infrastructure provider outlined the role of market infrastructures which is to offer "state of the art, efficient systems and services for all kinds of market participants across all product layers". A challenge for such providers is that the target is always changing and that infrastructures have to anticipate evolving needs. An example of this was given by the speaker. An electronic platform for inter-bank money market trading (GC Pooling)3 received very limited enthusiasm in the market when it was initially launched in 2005/06 on the basis that the existing money market worked well. It however turned out to be a great success in 2007/8 when traditional money markets froze and as the anonymity provided by the platform became a priority feature for many players who had understood that they could only get cash in the market through a CCP. This activity has however decreased to a certain extent again, now that the priority has again changed given the impact of the new prudential requirements on balance sheets. Another debate has now been initiated by some buy-side players who believe that it makes sense for them to place cash through the CCP to sale-side firms which can then place this cash again through the CCP into the market. This example illustrates the fact, the speaker stressed, that market infrastructures can contribute to mitigating liquidity issues but that they are constantly confronted with changing targets and new regulations. Finding an appropriate solution requires a close dialogue between infrastructure providers and all types of market participants, because regulation plays a key part in all these developments.
Infrastructure providers are also currently working on developing networks and partnerships, an industry representative explained, in order to help address the global fragmentation of bond markets and better serve the sale-side and buy-sides in particular. Most bond issues are indeed fragmented across the globe and some are now in central bank portfolios (with the QE programme). The difficulty is to mobilise these bonds due to time constraints, costs, and back office challenges. These market barriers need to be broken, but this is not easy, notably because these securities are safekept by different CSDs, agent banks or global custodians. This requires developing strategic partnerships in order to create the necessary connections between the different players involved and the technical solutions that may allow agent banks and global custodians to identify assets as soon as there is a demand e.g. from a buy-side client to cover an exposure.
Solutions put in place in the asset management sector
Solutions have begun to be put in place in the asset management sector, an industry representative emphasized. First, asset managers are reacting and adopting strategies to deal with the "new normal". Portfolio management and the construction of the portfolios themselves depend on the client and the situation, but the expectation is that there will be longer holding periods. Portfolios may be constructed differently as a result e.g. with back up sources of temporary liquidity available to meet either a spike in redemptions or a mismatch in settlements. Second, in the area of fixed income trading, the dynamics between the buy-side and the sell-side are changing. Asset managers are becoming "price makers" and not just "price takers", meaning that they are increasingly indicating the execution price that they will accept, rather than waiting for an offer. This requires a new skill set and analytical capabilities. In doing so asset managers contribute to price discovery and enhancing liquidity. Asset managers are also generally proponents of electronic platforms in order to supplement the liquidity provided by broker dealers. Thirdly, more resources are going into the examination of liquidity risk management with the increase of liquidity risks (e.g. with daily liquidity reports, stress tests of various adverse redemption scenarios…) for which further transparency on underlying assets could be helpful in some circumstances to better forecast future redemptions. Moreover best practices are being identified across the industry in order to have the appropriate tools (e.g. bank credit lines, inter-fund lending...) to be able to manoeuvre in different situations and have more flexibility.
Securities regulators are also very much aware of market liquidity risk issues, the industry representative believed. For example ESMA has already established rules for the stress testing of funds (in the AIFMD rules), the US SEC has issued several proposals for gathering additional data to develop a proposal for the stress testing of funds completing the guidance published a year and a half ago. When considering stress testing, it is important to note that asset managers and the funds they manage are quite different from banks, the industry speaker stressed. It is not possible to start with a banking framework and adjust it. Investment funds have a floating asset value, so it is the investors who are bearing the market risk, including the liquidity risk, unlike bank deposits where this risk is borne by the bank. So the liquidity stress test and any kind of stress test on a fund by definition has to be tailor made and has to start with this first principles approach.
A regulator also pointed out that much progress has been made notably in Europe to mitigate liquidity issues regarding investment funds that provide redemption commitments, with the introduction of stress testing obligations in UCITS IV (which have been reinforced with MiFID). There is a cost for the industry but this should provide relevant benefits, the regulator believed.
Going further requires a combination of actions from the public and the private sectors
A regulator considered that it may be better to "just let the market evolve" rather than trying to force a regulatory solution. Regulating such issues as liquidity is difficult because whilst the objectives are "certainly excellent", the market is evolving at the same time towards a new equilibrium and a new design of the market might "reserve a lot of surprises". Part of the problem in many markets is that they have not been allowed to have proper market discipline and to evolve in a proper way.
Achieving sustainable liquidity in markets should be a joint project of the industry and the official sector with a long term view, the regulator claimed. A four-fold approach for building sustainable liquidity markets was suggested. The first issue is market infrastructure. This includes (i) harnessing technology and building market trading platforms like ECNs; (ii) reducing transaction costs perhaps through block chain technology, which may allow to disintermediate clearing and settlement registrations and potentially intermediaries, thereby reducing transaction costs; (iii) providing access to derivative markets in order to hedge credit exposures; (iv) providing price discovery through post trade transparency. The second issue is developing markets that are "investor driven" and not just "issuer driven", as is often the case. This involves "thinking about what investors want". "Good" issuers are very focused on liquidity because they want investors to be there when they come to the market. This requires standardised documentation in order to simplify investment decisions and block chain technology will probably facilitate that also. Being "index driven" is also important as well as other techniques used by sovereigns such as issuing into the same tranche to build liquidity. Having good investor communications is also essential. These are different elements which can help to develop more investor focus. A third issue is market access and building a global market. This requires breaking down barriers and fostering mutual recognition between markets. The wider the market access, potentially the more investors and the more liquidity are available. Block chain technology which is borderless may again help to build more liquid markets in this perspective. The fourth point is capital liquidity charges which should be "neutral", whereas in some areas of fixed income markets there are clearly distortions in the capital charges.
A market observer agreed that the industry needs to adjust to a lower liquidity environment and that the final calibration of banking reforms needs to be carefully thought out by policymakers.
An industry representative stated that different factors impact liquidity and in order to identify possible solutions some concepts need to be established regarding the buy-side in particular. One concept to consider is market risk versus systemic risk. The financial reforms following the crisis have made banks more resilient. This is evidenced by some recent events such as: the change in the currency exchange rate implemented by the Swiss National Bank, the expansion of the bond buying programme in Japan, the major QE programme launched by the ECB and the flash rally or flash crash of the US Treasuries market. Throughout all of these events which were quite significant, there was no major bank failure or systemic impact. The risk taking behaviours that were seen pre-crisis with leverage, massive proprietary trading and betting do not happen today and that is good for systemic risk, bank resilience and society, the speaker emphasized. Another element to consider is that there are many different kinds of asset owners (e.g. insurance companies, pension funds, sovereign wealth funds, individuals...). Moreover, the so-called buy-side is composed of asset owners and asset managers and asset owners have the choice to manage their money themselves or to give that money to an asset manager that will manage it for them. Asset owners also have different incentives (e.g. tax constraints) and have liabilities with different horizons. In such a context asset owners might have different reasons for providing liquidity and in a falling market those that step in often do so opportunistically.
Looking at what more could be done to improve market liquidity, the industry representative considered that additional solutions may be considered in three areas. First, market structure clearly needs to be modernised. Derivative rules have been changed and the role of CCPs has expanded. The market structure for fixed income can be modernised too, supplementing principal trading with more agency trading on electronic trading venues. Furthermore, settlement procedures on bank loans could be standardised in order to transform bank loan assets into "security-like" instruments which would help to improve the liquidity of the market. A second area of improvement is fund structures which are regulated differently around the world and could be standardised to the best of worldwide practice. Practices such as redemption in kind could be permitted or even encouraged when there is a large redemption from a fund with an institutional investor. Out-of-the-money gates5 could also be allowed as is the case for UCITS to help mitigate tail risks in addition to other tools such as pricing mechanism to allocate transaction costs to transacting investors (reducing run risks or first mover advantages) and allowing temporary borrowing for short term purposes. Finally, the contribution that product innovations could bring to liquidity should be considered. ETFs (Exchange Traded Funds traded on exchanges) may be part of the solution, the speaker emphasized. ETFs allow multiple buyers and sellers to meet directly just like in the equity market and also aggregate bonds. Fixed income ETFs therefore provide a means to trade bond exposure on exchanges, creating an additional source of liquidity that cannot be provided by OTC markets in stressed situations.
A regulator noted that the new Market Abuse Regulation (MAR) is very important in the construction of a better capital market at least in Europe and will be an important pillar of the CMU. MAR extends market abuse rules to all types of instruments as it applies to all different types of trading platforms and also to all OTC trades, ensuring that there is no abusive behaviour and no illegal practices. This should have a positive effect on the price of financial instruments traded on regulated electronic platforms.
Another relevant issue, the regulator emphasized is the definition of market-makers. Current discussions are focused on the premise that all dealers are liquidity providers, but this is not necessarily the case because there are not always clear rules that oblige them to stay in the market. In a number of markets and trading platforms, only some of the dealers operate under liquidity provision contracts with clear obligations to stay in the market and to provide liquidity unless a major event occurs. Such dealers should be clearly distinguished and conditions established, the regulator believed. More leniency could be granted and appropriate incentives provided for dealers with liquidity provision obligations so as not to discourage them from staying in the market.
The impacts of regulatory changes need to be carefully managed
An industry representative commented that when considering regulatory changes, it is necessary to "think carefully" before changing things that are already working. This does not necessarily mean "not harming" certain players. What is important is making sure that the savers, "the people with pensions and jobs" are not negatively impacted. The crucial issue is how to ensure funding is provided for companies and how to ensure the money people have saved in pensions or otherwise is invested.
A policy maker stressed that regulations usually lead to changes in the market and therefore to "some harm" being done to certain participants but that overall the balance should be positive for the market as a whole. This should be the case of the CMU notably which is expected to benefit capital markets but should trigger some evolutions in the structure of the market. Today, issuers or dealers dominate the market and as there are not so many dealers they have a certain market power which they are reluctant to lose. If the power moves to the buy-side there may again be a concentration aspect on the buy-side, because the size of some asset managers gives market power to them as well. This will change the nature of competition. The development of global networks (e.g. between CSDs, agent banks and global custodians) will also impact competition notably because information will be shared. The right balance needs to be found in order to avoid closing the market and reducing innovation and creating false positives and negatives. These are difficult aspects to be considered in relation to CMU that will build on what has already been achieved with MiFID.
Further improving transparency
Different views were expressed among the panellists about how transparency could help to solve market liquidity issues and some related issues.
Post trade transparency is important for liquidity, an industry representative emphasized as it can help investors who have less access to information in their investment decisions, such as retail investors and also some asset managers. In the US where there is very good data on the (high) yield market there is "valid" liquidity. This transparency can help people who are otherwise not as well informed about the prices and without harming the wholesale market.
A regulator commented that there is also a role for regulators in improving transparency. One place where there is very heavy responsibility on EU authorities to get this right is in the MiFID II pre-trade and post-trade transparency regime. MiFID II will increase transparency in the market, which will facilitate regulatory monitoring and price discovery, which is also good for the buy-side. If the right choices are made this will help preserve and sustain liquidity in a range of instruments that already have a minimum level of liquidity and make such transparency requirements acceptable for the market-makers who are going to continue to have a role in preserving liquidity. However, if illiquid instruments are made subject to the transparency regime and if market-makers are asked to declare transactions "whenever they take an asset onto their inventory" this could be damaging, the regulator believed.
The regulatory community has been working very hard to see whether it is possible to classify bonds into liquid and illiquid according to criteria like the issuing size and so on. It is apparent that any such approach is very inaccurate and will create many "false positives". This is worrying for the buy-side because they might have to shift some assets in their portfolios unnecessarily and at a price that may have gone down. This could also be damaging.
The second point to consider in the CMU context is the impact on secondary market liquidity of the primary market legislation. For example, in 2012 when the prospectus directive was last revised there was a rule that a bond in denominations lower than 100,000 Euros would require extra disclosure. The idea was to protect retail investors who might buy smaller denomination bonds. The reaction of the market however was to reduce the issuance of bonds in denominations under 100,000 Euros, so in fact now only a sixth of EU investment grade bonds are in those small denominations. Yet according to TRAX, over half of all trades in EU investment grade bonds are for much less than 100,000 Euros, which means that if the Prospectus directive is not reviewed half of all trades might be ruled out. This link between primary and secondary markets should be examined as part of the CMU agenda.
Analyzing market fundamentals
A regulator stressed that one must also be cautious of "false heavens" that may exist in terms of liquidity. Back in 2007 on Wall Street, there appeared to be so much liquidity that market participants believed that they would no longer need banks. The key is to recognise that often fundamentals have not changed. Suddenly that high yield bond that seemed really liquid could no longer be traded. The regulator believed many people are still ignoring reality at present and living in a false heaven. Market participants have to adjust to the new market conditions and assess the fundamentals of the assets. Some bonds fundamentally do not have a deep market. This is just a reality check.
A regulator agreed that working out the impact of change, not only on regulation but on market structure and risk appetites is an important part of market intelligence. In some cases a trade is not executed because the conditions are not acceptable for one of the counterparties, then the next question is whether the price at which the trade can be executed actually reflects rightly the risks involved for the counterparty on the other side of the trade. If this is not the case and the price is disproportionately expensive compared with the risk then the impact of the regulatory mix may need to be further assessed.
1 See PWC study on Global Financial Markets Liquidity – August 2015
2 There has been an increase in the number of bonds outstanding over the past few years. Proposals have been made to reduce the number of distinct bonds e.g. with a greater use of benchmark issues by larger issuers (larger consolidated issuance as opposed to smaller sporadic issuance).
3 GC Pooling offers an electronic platform for secured money market trading on an anonymous basis for EUR and USD funding against standardized fixed income and equity collateral baskets as well as baskets of ECB-eligible securities which can be reused directly to access ECB credit facilities. The CCP ensures anonymous trading plus an efficient, centralized risk management process across all products.
4 These ideas are further developed in Blackrock's viewpoint "Addressing market liquidity" July 2015
5 An out-of-the-money gate (OTM) is a gate where the trigger for considering whether to put the gate down is sufficiently unlikely to be triggered under normal market circumstances, so as to only be triggered in emergency or extraordinary circumstances. OTM gates are currently permitted under UCITS and the EIMD in Europe.
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