Liquidity – a double-edged sword
Financial industry lobbyists are using concerns about market liquidity to try and scare policymakers away from necessary reforms to bank structure and capital. This renewed focus on financial market liquidity risks confusing the symptom with the cause. If policymakers react in the wrong way to “liquidity lobbying”, they risk leaving us with more short term investing and a financial system that is more fragile and pro-cyclical than it needs to be.
A market is said to be liquid if an investor can sell a relatively large holding over time without the price moving against them.
But financial market liquidity is a double edged sword. On the plus side, liquidity helps the functioning of the market in normal times as market participants can easily find buyers when they want to sell and vice versa.
On the negative side, markets can overreact very quickly; one can have too much of a good thing.
A year after the financial crisis, the influential Turner Review concluded that banks’ overreliance on liquid markets was a major contributor to the global financial crisis. Many regulatory reforms and proposals followed, some of which are still being negotiated or finalised.
Today, seven years after the crisis, regulators are worrying about liquidity again. In recent weeks, the prices of corporate and sovereign bonds have become more volatile. There are concerns about Greece, liquidity (Economist, FT), markets not functioning as normal (FT) and even about whether liquidity problems could spark a new crisis (WSJ, Reuters).
Some financial industry lobbyists are using this liquidity concern to push for easier rules on bank trading and asking for proposals to restructure megabanks to be dropped, for example. As a number of large banks have seen their ‘FICC’ (fixed income, currencies & commodities) trading revenues decline nearly every quarter for five years (FT), a regulatory backtrack would be appealing for them.
But would it help markets and the economy? We are doubtful. Short-term liquidity problems may need treating as a symptom, but not as the cause. We urge policymakers to remember the lessons of the crisis and to be wary about how they react to “liquidity lobbying”.
For the market as a whole, liquidity is a means to an end, not an end in itself. What John Kay noted about equity markets could be applied to other markets too: “It does not follow that the degree of liquidity is the proper measure of the effectiveness of equity markets”.
First, market liquidity is very procyclical - think of it as a tide - being highly dependent on investors' greed and fear, and can decline very quickly in times of stress: as most investors tend to herd, they typically all want to invest when the market goes up and sell when markets turn. This is problematic given financial markets' well known manic-depressive behaviour and their tendency to overreact irrationally from time to time.
Secondly, the current excessive focus on liquidity and tradability encourages the excessively short term approach of investors and does not encourage due diligence: investors may instead rely on being able to sell very quickly if they change their mind.
In contrast, investing in illiquid assets incentivises investors to buy for the long term and to truly assess the risks of the assets, knowing that they will not be able to sell quickly in a market downturn.
The chief investment officer at JPMorgan’s asset management arm, Robert Michele, summed it up when he said that lacklustre trading could “force people in the market to be investors again, rather than just traders” (FT).
Thirdly, and most importantly, a procyclical market requires countercyclical entities: when everybody wants to sell, somebody must be willing and able to buy in order to prevent a market crash. In the case of banks, the European Central Bank plays that role. In the case of non-banks (also called shadow banks), no one plays that role effectively since shadow banking does not have access to public safety nets. In order for our financial system to be stable, some regulators have therefore asked whether the size of the shadow banking sector should be restricted (NY Fed). Yet we are currently doing the opposite and promoting the growth of shadow banking via the Capital Markets Union.
A first step is to quantify the problem, which means looking at some of the measures used to assess liquidity. The turnover ratio, which compares trading volumes with outstanding amounts, has been used to suggest that liquidity for corporate bonds has declined in many jurisdictions. But if corporate bonds have indeed become less liquid, it is not because trading volumes are lower. Rather, it is because trading volumes have not kept pace with the surge in debt issuance in many advanced and emerging market economies. A boom in primary issuance suggests a market in good health. What the turnover ratio shows is a reduction in churn, which says little about market diversity and may be a benefit if it reduces costs for end-investors.
The bid-ask spread measures the difference between the price at which a security can be simultaneously bought and sold – a transaction that John Kay noted would never be undertaken by an investor. In the sovereign bond market, bid-ask spreads have broadly returned to levels before the global financial crisis. But in markets where they have increased this may simply indicate better pricing rather than a liquidity problem, as new regulations force banks to bear more of their own risk (the miss-pricing of risk was another major factor cited as a cause of the financial crisis).
Low measurements of liquidity could have several explanations: for example greater concentration in the asset management sector increases the liquidity impact of decisions by big players. Or quantitative easing could affect liquidity where large quantities of certain assets are removed from the market. So it does not follow that a decline in liquidity is caused only by regulation, or that removing certain regulations will restore liquidity.
In fact, liquidity concerns may well be a symptom of deeper problems that these same regulations are designed to prevent. Former Citigroup CEO Chuck Prince famously said: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.” In that case, it was doubts about solvency that stopped the music, and liquidity problems were the consequence.
The recent volatility in corporate and sovereign bond markets raises the same question: is it a new problem caused by new regulation, or a version of the same problem as before – an over-reliance on short term market liquidity – that regulation has not gone far enough to cure?
Keynes’s comment that none of the maxims of orthodox finance are “more anti-social than the fetish of liquidity” suggests that it is an old problem. His reasoning is just as relevant today: the doctrine of liquidity, he wrote, distracts investors from their social object and forgets that there is no such thing as liquidity of investment for the community as a whole (General Theory, chapter 12, section V.4).
A primary focus on liquidity makes sense for intermediaries whose business is transaction-based. For policymakers facing “liquidity lobbying” and for the wider economy, it could be worth taking a more detached view.
- The Great Wave off Kanagawa, by Katsushika Hokusai