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"Artificial" Phantom Liquidity Will Disappear In "Adverse, Turbulent" Markets, BIS Warns

Tyler Durden's picture




 

The BIS — the bank for central banks that, in a world characterized by heightened calls for transparency and accountability, remains completely opaque and unaccountable — is out with its latest annual report, and as usual, there’s quite a bit of no-nonsense analysis of the conditions facing global financial markets.

Of particular note is the bank’s assessment of bond market illiquidity, a topic which we first raised years ago and which has since become the favorite talking point of every reporter and pundit out to prove how in tune they are to the undercurrents that threaten to bring about the next crash. 

And while everyone who has even the faintest conception of the forces currently at play in credit markets has by now pretty much accepted the fact that a supply bonanza sparked by artificially suppressed borrowing costs and voracious demand from yield-starved investors is a very dangerous thing when paired with a secondary market devoid of market makers, what has yet to become the topic du jour is the fact that bond fund managers’ use of ETFs to meet redemptions when flows are diversifiable (which allows them to avoid tapping illiquid corporate credit markets) creates an illusion of liquidity and serves to make the underlying bond market all the more illiquid as trading dries up. This only works however, until flows become unidirectional (i.e. non-diversifiable).

Without further ado, here’s the BIS’ take on the state of today’s illiquid credit markets.

There are two aspects to market liquidity. One is structural, as determined by factors such as investors’ willingness to take two-way positions and the effectiveness of order-matching mechanisms. This type of liquidity is important in quickly and efficiently dealing with transitory order imbalances. The other reflects one-sided, more persistent order imbalances, as when investors suddenly all head in the same direction. If investors persistently underestimate and underprice this second aspect, markets may appear liquid and well functioning in normal times, only to become highly illiquid once orders become one-sided, regardless of structural features. 

 

In the wake of the financial crisis, specialised dealers, also known as marketmakers, have scaled back their market-making activities, contributing to an overall reduction in the liquidity of fixed income markets. For example, the turnover ratio of US Treasuries and investment grade corporate bonds, calculated as the ratio of primary dealers’ trading volume to the amount outstanding of respective securities, has been on a declining trend since 2011. Some of the drivers for this retrenchment are related to dealers’ waning risk tolerance and reassessments of business models (Box VI.A). Others have to do with new regulations, which are aimed at bringing the costs of market-making and other trading-related activities more into line with the underlying risks and those they generate for the financial system. Finally, increasing official sector holdings of government securities may also have contributed to lower market liquidity. 

 

Changes in market-makers’ behaviour have had varying effects on the liquidity of different bond market segments. Market-making has concentrated in the most liquid bonds. For example, market-makers in the United States have trimmed their net holdings of relatively risky corporate bonds while increasing their net US Treasury positions (Graph II.11, left-hand panel). At the same time, they have cut the average size of relatively large trades of US investment grade corporate bonds (Graph II.11, centre panel). More generally, a number of market-makers have become more selective in offering services, focusing on core clients and markets. 

 

 

Another key change in bond markets is that investors have increasingly relied on fixed income mutual funds and exchange-traded funds (ETFs) as sources of market liquidity. Bond funds have received $3 trillion of investor inflows globally since 2009, while the size of their total net assets reached $7.4 trillion at the end of April 2015 (Graph II.12, left-hand panel). Among US bond funds, more than 60% of inflows were into corporate bonds, while inflows to US Treasuries remained small (Graph II.12, centre panel). Moreover, ETFs have gained importance in both advanced economy and EME bond funds (Graph II.12, right-hand panel). ETFs promise intraday liquidity to investors as well as to portfolio managers who seek to meet inflows and redemptions without buying or selling bonds. 


 

The growing size of the asset management industry may have increased the risk of liquidity illusion: market liquidity seems to be ample in normal times, but vanishes quickly during market stress. In particular, asset managers and institutional investors are less well placed to play an active market-making role at times of large order imbalances. They have little incentive to increase their liquidity buffers during good times to better reflect the liquidity risks of their bond holdings. And, precisely when order imbalances develop, asset managers may face redemptions by investors. This is especially true for bond funds investing in relatively illiquid corporate or EME bonds. Therefore, when market sentiment shifts adversely, investors may find it more difficult than in the past to liquidate bond holdings. 

 

Central banks’ asset purchase programmes may also have reduced liquidity and reinforced liquidity illusion in certain bond markets. In particular, such programmes may have led to portfolio rebalancing by investors from safe government debt towards riskier bonds. This new demand can result in narrower spreads and more trading in corporate and EME bond markets, making them look more liquid. However, this liquidity may be artificial and less robust in the event of market turbulence. 

So what's the solution? Unfortunately there really isn't one, unless you count the BIS' feeble recommendations which include conducting more stress tests (which are everywhere and always a joke) and educating policymakers on the dangers of illiquid markets (good luck with that).  

Instead, fund managers are simply resorting to emergency liquidity lines with banks which, as we outlined first in "ETF Issuers Quietly Prepare For Market Meltdown With Billions In Emergency Liquidity" and then in "How ETF Issuers Use Phantom Liquidity To Avert A Meltdown," is just another manifestation of using cheap cash to delay the Schumpeterian endgame scenario which, if ever allowed to play out, will finally purge capital markets, reset the system, and free the world from the nefarious clutches of central bankers gone mad with delusions of Keynesian grandeur. 

 

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Sun, 06/28/2015 - 12:50 | 6244840 chunga
chunga's picture

Knocking out the central bankers would be creative destruction indeed.

Way to go Tyler.

Sun, 06/28/2015 - 13:07 | 6244951 ZH Snob
ZH Snob's picture

this is like getting a lecture from the head of the mob who sent his flunkies to destroy your livelihood so you would now understand how much you need them to stay in business.

Sun, 06/28/2015 - 13:11 | 6244988 cossack55
cossack55's picture

Is Angie Merkel really Hjalmar Schacht in drag?

Sun, 06/28/2015 - 14:36 | 6245434 Pinto Currency
Pinto Currency's picture

 

 

The BIS which is the central coordinator for rigging gold markets and thus interest rates is warning us about liquidity after they've facilitated a massive global debt bubble over decades which is now collapsing.

Sun, 06/28/2015 - 13:13 | 6244999 Veriton
Veriton's picture

The central bankers will shut down the central banks they own and run the money system from the treasury departments they own.

Sun, 06/28/2015 - 22:50 | 6247600 old naughty
old naughty's picture

there may only be one department...no "s".

You think all these tests in their lab (eh, "club") they were looking at multiples in the end?

The wizard is coming out from behind the curtain !

Sun, 06/28/2015 - 13:38 | 6245182 BullyBearish
BullyBearish's picture

What do we want?  WEXIT!!

When do we want it? NOW!!

WEXIT = ELIMINATION of Banking influence on the WEST...Give us back our F&*(^king Countries!!

Sun, 06/28/2015 - 14:03 | 6245299 Model T
Model T's picture

"Liquidity Illusion--"  I like that. I couldn't have said it better myself. Everybody forgets, (because it's unpleasant, and why dwell on unpleasant things ?); that when they're too many sellers and no buyers; THERE IS NO LIQUIDITY.  This is the huge difference between funny money and Silver and Gold coinage; Silver has no counterparty; it just -IS-; already, in itself.  I was in Mexico during one of the "Peso Crises"; I guess it was "the peso crisis" according to the main stream story.  You just won't believe what happens when people panic; you won't believe it. I rented a nice hotel room on the third floor in La Pax, BC, over-looking the beach, for about $7.35 / day; I rented it for six months, and paid with Mexican Silver Coins. Temporary Insanity ? Yeah, of course; but how do the business men know this isn't the "big one"; the one where there won't be anymore Pesos ? They don't know; and they know they don't know, and they panic. Since I'm smart; unlike most people; I already had the Coins in a Safety Deposit Box in the National Bank of Mexico. I wouldn't do that now, of course, in the US; Mexicans are a lot more honest than American Politicians. I just gave the Bank VP one coin, for a "friendship present"; and I was their fair haired boy.  I wonder what you'll be able to buy in Greece next week for a Silver Phillharmonic ? Probably a lot more than you think. It's not a question of what is the price ? Eventually, there is no price; because nobody is stupid enough to sell Silver for "money" that's going out of style; but real stuff ? A Cow ? Rent ? Female Household help ? well, that's a different story.

Sun, 06/28/2015 - 14:18 | 6245380 Model T
Model T's picture

"--persistent order imbalances--"  yeah, boy.  all sellers and no buyers; and did they invent a magic fix for this fundamental human problem ? Nope. That's what they're saying; there is no magic fix. I love reading this kind of stuff; this is the real reasonl you own Silver; BECAUSE THERE'S ALWAYS A BUYER.  And the more freaked out they get about their failing paper game they were having so much fun playing; THE MORE T HEY OFFER YOU FOR THE SILVER.

Sun, 06/28/2015 - 21:12 | 6247167 eforce
eforce's picture

They aren't even the ones really in control, they will take the fall as the NWO marches on, after the peasants have had their taste of blood.

Sun, 06/28/2015 - 12:53 | 6244854 MsCreant
MsCreant's picture

Is "the shit hitting the fan" liquidity?

Sun, 06/28/2015 - 13:50 | 6245229 RiverRoad
RiverRoad's picture

And how liquid is all that hypothecation?

Sun, 06/28/2015 - 14:06 | 6245313 Model T
Model T's picture

No, actually; it's the drying up of Liquidity that's the "Shit hitting the Fan"; it doesn't really work as a metaphore.

Sun, 06/28/2015 - 14:24 | 6245412 RiverRoad
RiverRoad's picture

Yeah, but it's funny anyway.

Sun, 06/28/2015 - 12:54 | 6244860 angel_of_joy
angel_of_joy's picture

Can't wait for the day when the algos will tell the human assholes on Wall Street to fuck-off...

http://blogs.wsj.com/digits/2015/06/26/artificial-intelligence-machine-g...

Sun, 06/28/2015 - 12:56 | 6244873 Bighorn_100b
Bighorn_100b's picture

Who gave the order to turn off the ALGOS? /s

Sun, 06/28/2015 - 13:05 | 6244942 q99x2
q99x2's picture

When bankers fail we have the DHS.

Sun, 06/28/2015 - 13:18 | 6245035 buzzsaw99
buzzsaw99's picture

yeah, sure, blame regulations. if only the maggot big banks could buy infinite shit and make infinite bonuses until they need another bailout everything would be great. /SARCASM

Sun, 06/28/2015 - 13:19 | 6245045 buzzsaw99
buzzsaw99's picture

if it all goes wrong the fed will step in and the bis damn well knows it.

Sun, 06/28/2015 - 13:52 | 6245240 negative rates
negative rates's picture

The Fed, always wrong, but never in doubt.

Sun, 06/28/2015 - 14:09 | 6245329 Carpenter1
Carpenter1's picture

No, not this time.

 

FED could've prevented 2008, but didn't.

 

Think about that

Sun, 06/28/2015 - 13:20 | 6245056 buzzsaw99
buzzsaw99's picture

fund managers who buy bonds on margin AREN'T INVESTORS

Sun, 06/28/2015 - 13:24 | 6245085 disabledvet
disabledvet's picture

Well, indeed...they are in fact "risk managers" who are properly diversified as equities and the dollar hit one high after another...

Sun, 06/28/2015 - 13:30 | 6245126 buzzsaw99
buzzsaw99's picture

they are speculators who get big bonuses when they jack prices higher and higher and can never lose because it isn't their money anyway. hey joe, maybe if i margin buy this and ir swap that and then, yep, BONUS TIME!

Sun, 06/28/2015 - 14:08 | 6245321 Model T
Model T's picture

No, of course they aren't. Actually anyone who buys bonds, in this environment, (maybe in 1923, but not today); on or off margin is a fool.  "Bonds, Instruments of Guaranteed Confistication".

Sun, 06/28/2015 - 13:22 | 6245066 disabledvet
disabledvet's picture

Ummm..."say Hello to the Ford Class Aircraft Carrier...

Sun, 06/28/2015 - 13:45 | 6245209 Metalredneck
Metalredneck's picture

No match for the S-300...

Sun, 06/28/2015 - 14:10 | 6245333 Model T
Model T's picture

That Head Wound is acting up again, huh ? Boy are you out of it.

Sun, 06/28/2015 - 13:46 | 6245212 teslaberry
teslaberry's picture

at which point the bis then tells central banks to print more money?

 

 

LETS FACE IT---the BIS IS PLAYING A DIFFERENT GAME, ONE OF EMPIRES, AND SPIES, AND SECRET TRAITORS . THIS IS TRULY THE ILLUMINATI HERE.

 

money is the tool, the object power. the bis will use all tools at its disposal, humanity at large and all our accoutrments including agitating world wars.

Sun, 06/28/2015 - 13:53 | 6245245 WTFUD
WTFUD's picture

Phantom = SPECTRE

Sun, 06/28/2015 - 14:02 | 6245290 Soul Glow
Soul Glow's picture

This has to be bullish somehow!

BUY SILVER

:)

Sun, 06/28/2015 - 14:12 | 6245341 Model T
Model T's picture

If you have a five year time line; I doubt very much if you'll regret it. All the little ducks are lined up in that direction.

Sun, 06/28/2015 - 15:09 | 6245643 Soul Glow
Soul Glow's picture

5 years?  Are you joking?

Greece is defaulting!  

Silver and gold prices are going to explode!

Sun, 06/28/2015 - 15:34 | 6245768 Model T
Model T's picture

It's important for you to understand that your opinions are not the same as reality.

Sun, 06/28/2015 - 19:49 | 6246897 daveO
daveO's picture

Sooner or later. Have they've already cleaned out the 'physical' vaults? Remember their visit w/ the sock puppet was only 3 weeks after Cyprus. Did they get a permission slip to clean out the vaults at that time? If not, they'll be back. 

http://www.bloomberg.com/news/articles/2013-04-10/obama-is-said-to-plan-...

Sun, 06/28/2015 - 15:36 | 6245773 mccvilb
mccvilb's picture

Right. Slightly dyslexic and you omitted the T.

Silver hit a high in '87 then traded down and flat for twenty years between four and six bucks. Where's Cramer and his augha horn? Buy now at 15.80 all you "smart investors". They can make it whatever they want, liquidity or not, fiat or not. When one party holds absolute control over the flow only "they" know the vaults were emptied. Wait until E1 says start dumping. Water's the commodity du jour.

Sun, 06/28/2015 - 14:52 | 6245569 CarpetShag
CarpetShag's picture

The name is Bonds. James Bonds.

Sun, 06/28/2015 - 15:22 | 6245711 Soul Glow
Soul Glow's picture

Bonds are for suckers.  The real rate of return is poor considering inflation is guaged above 10% YoY.  Bonds even with slightly elevated prices aren't yielding that.

And you'll be paid out in worthless fiat paper so if the bond market does collapse even if you get out early you'll be paid in worthless dollars.

Fiat is a dead currency.

Sun, 06/28/2015 - 19:54 | 6246920 daveO
daveO's picture

Here's the proof. 

https://www.whitehouse.gov/blog/2014/02/11/myra-helping-millions-america...

In the mean time, pay your Health Insurance premium for nothing, comrade.

Sun, 06/28/2015 - 14:54 | 6245580 RaceToTheBottom
RaceToTheBottom's picture

Whatever you do, don't talk about everyone getting into gold at the same time....

Talking about gold as an investment vehicle is the third rail of Wall Street.

Sun, 06/28/2015 - 15:20 | 6245697 Soul Glow
Soul Glow's picture

Gold doesn't have a buy listing for any major firm!  

Are you nuts?!

Sun, 06/28/2015 - 14:55 | 6245584 jmc8888
jmc8888's picture

Allowing the markets to reset is NOT fascist Creative Destruction.

 

 

Mon, 06/29/2015 - 02:43 | 6248068 polo007
polo007's picture

According to Macquarie Research:

http://personal.crocodoc.com/lHeFs3w

China drama & Greek farce

Are Central Banks at the end of the road?

Greek and Chinese dramas question role of Central Banks…

- The latest developments in China and the Eurozone inevitably invite the question whether Central Banks are coming to the end of the road. Given the limited impact of their policies on real economies with stimulus largely being confined within walls of financial assets, has the time of reckoning finally arrived?

- As discussed in the past (here & here), the only sustainable LT outcomes for the over-leveraged and over-supplied global economy are either: (a) allowing the deflationary cycle to go through, thus eliminating global excess capacity in service and merchandise economies; (b) elimination of excess debt via some form of hyperinflation and/or co-ordinated debt cancellation; or (c) banning capital markets via nationalization. Given that neither of these alternatives is attractive, involving pain for either borrowers or savers; intergenerational transfers or courting sharply lower ROIC, CBs would rather kick the can down the road in the hope that a solution would be eventually found.

…and should CBs place monetary policies in neutral gear?

- PBoC’s half-hearted attempts last week to slow the pace of appreciation of the equity market have inevitably and predictably resulted in severe correction. The double-barrel reduction in interest rates and RRR on Saturday is a belated realization that it is courting a significant economic backlash. As discussed here, we do not believe that China’s de-leveraging is either possible or desirable. Having reached leverage of ~3:1, any debate about the evils or virtue of debt has passed a long time ago, and the only viable choice from now on is to continue leveraging, though perhaps at a somewhat slower and safer pace.

- In order to continue leveraging, PBoC has to make sure that: (a) there is no sharp correction in any of the key asset prices; (b) at least some asset prices are appreciating; and (c) there is no further contraction in nominal GDP. This requires a combination of exceptionally stimulative monetary and fiscal policies as well as trust that a country is not yet in a liquidity trap and that it is capable responding to stimulus in safeguarding nominal GDP. The game is no longer about reaching 7% real GDP growth but avoiding zero nominal GDP.

- The same dynamics are playing out in Europe. The battle is between politicians who have not yet grasped that deleveraging is no longer feasible, and the ECB, which is fully onboard. Whether Greece is allowed to exit does not alter the basic argument that the numbers do not work, unless leveraging continues.

China is at very early stages of stimulus

- We maintain that China is at an early stage of significant (probably the largest globally) stimulative action. We expect that over the next two years, RRRs would be reduced to historic levels (i.e. 5-6%); interest rates would be lowered to zero and fiscal spending would become much more aggressive (including multiple banking re-capitalizations). The only question is whether China would send a massive inflationary pulse through global economy or would aim for more moderate impact. Initially, the PBoC would be aiming for moderate outcomes, ensuring support for asset prices but avoiding more disruptive action. However as we progress into 2016-17, more drastic actions might be needed. In the meantime, we remain O/W MSCI China, as equities remain the least systemic asset class that can be leveraged, at least for now.

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