"Nor Any Drop To Drink," Citi Maps The Liquidity Paradox

For years (literally), we’ve been warning about the dangers of increasingly illiquid credit markets. In short, Fed purchases have sucked the Treasury market dry contributing to a shortage of high quality collateral in the process, a situation which, when coupled with hair-trigger HFTs, can lead to dramatic displays of volatility such as last October’s Treasury flash crash

Meanwhile, new, post-crisis regulations ostensibly designed to protect investors from evil prop traders (whom we’re absolutely, positively sure did not find a way around Volcker the very second it was conceived) have also served to make Wall Street less likely to hold inventories for market making purposes, meaning the secondary market for corporate credit is as dry as California. The lack of liquidity in corporate credit markets couldn’t come at a worse time. Yield-starved investors have been herded into corporate debt after central banks drove yields on risk-free assets into the ground, leaving market participants with little choice but to venture into IG and then into HY. Corporations have been more than happy to oblige by issuing record amounts of debt (the proceeds from which are plowed into buybacks) at what, to management teams, seem like bargain-basement borrowing costs, but what to investors look like great income-generating opportunities compared to the growing number of government bonds that actually have a negative carry. 

And so, with the entire financial universe suddenly fixated on liquidity (or a lack thereof), we bring you the following from Citi’s Matt King:

From the BIS to BlackRock, and Jamie Dimon to Jose Vinals, everyone seems to be talking about market liquidity. Chiefly they seem to be fretting about a lack of it. Primary markets might be wide open, thanks in large part to the largesse of central banks, but the very same investors who are buying today seem deeply concerned about their ability to get out tomorrow…


We take issue with the widespread notion that the problem is solely due to regulators having raised the cost of dealer balance sheet, and could be ameliorated if only there were greater investment in e-trading or a rise in non-dealer-to-non-dealer activity. To be sure, we see the growth in regulation – leverage ratio and net stable funding ratio (NSFR) in particular – as one of the main reasons why rates markets are now starting to be afflicted, and indeed we expect further declines in repo volumes to add to such pressures. But illiquidity is a growing concern even in markets like equities and FX, which use barely any balance sheet at all, and where e-trading is the already the norm rather than the exception.


Instead, we argue that in addition to bank regulations, there is a broad-based problem insofar as the investor base across markets has developed a greater tendency to crowd into the same trades, to be the same way round at the same time. This “herding” effect leads to markets which trend strongly, often with low day-to-day volatility, but are prone to air pockets, and ultimately to abrupt corrections. E-trading if anything reinforces this tendency, by creating the illusion of lliquidity which evaporates under stress.


To date, the air pockets and flash crashes represent little more than a curiosity, having mostly been resolved very quickly, and having had little or no obvious feed-through to longer-term market dynamics, never mind to the real economy.


But we think ignoring them would be a mistake. Each has occurred against a largely benign economic backdrop, with little by way of a fundamental driver. And yet with each one, investors’ nervousness about the risk of illiquidity is likely to have been reinforced. When the time comes that investors do see a fundamental reason all to sell – most obviously because they start to doubt the extent of central banks’ support – their desire to be first through the exit is liable to be even greater.

While a cursory look at bid-offers seems to paint a healthy picture liquidity wise (tighter is better)…

...a look at annual turnover across markets reveals the truth…

King also points to the fact that flows into mutual funds may be setting the stage for a veritable maturity mismatch massacre, as investors move from money market funds (the 'old' cash substitute which now, thanks to central bank policy, yield next to nothing) where investments in commercial paper and other short-term securities make the duration gap less of an issue, to long-term funds (the apparent 'new' cash substitute which at least offer some semblance of yield) where a sudden wave of withdrawal requests could pose a potentially large problem given the longer-term investment horizon:

Until the early 1980s, more than half of the corporate bond market was held by pension funds and insurance companies, who might reasonably be considered long-term holders. In recent years, the growth in their holdings has not kept pace with that of mutual funds, households and foreign investors (Figure 12) – whose intention to hold credit could conceivably prove much more fickle.


Such concerns have been exacerbated by the negative correlation between mutual fund inflows and money market fund flows (Figure 13) – which has increased since the crisis (Figure 14). This suggests that investors have seen mutual funds as a substitute for cash, and raises the worrying possibility that they might potentially decide to sell them en masse if risk appetite were to wane or yields on cash were to become more attractive.


And of course many believe that reduced dealer balance sheets will ultimately be the catalyst that turns a bad situation into a meltdown:

But if neither ETFs nor mutual funds can be held responsible for perceptions of reduced liquidity across markets, what can? The finger is most often pointed at the street. Many buysiders feel that dealers’ willingness to act as a liquidity provider even during good times has waned; might such reduced willingness also help explain an increased tendency of liquidity to evaporate altogether? We think this is much closer to the truth – but even so, we doubt it is the full story.


As repo volumes have fallen post-crisis, so too has turnover, in liquid fixed income markets in particular (Figure 18 and Figure 19). The only market not to have been affected seems to be Japan (Figure 20), where repo is traditionally conducted by securities houses exempt from bank regulation.


To date, the major constraint seems to have been leverage ratios. The widespread reduction in dealer balance sheet sizes in general, and repo in particular, has been a direct consequence of banks’ efforts to surpass 3% leverage targets in Europe and higher 5%/6% targets under Supplementary Leverage Ratio requirements in the US (Figure 21). As far as we can tell, the small number of banks increasing repo activity have either started with higher leverage ratios or else seem convinced that their national regulator will prove more lenient. It is no coincidence that banks which historically had some of the weakest leverage ratios, like UBS and Deutsche, are among those to have made the most obvious cuts to their activities in fixed income (Figure 22).



These, dear friends, are your markets on central planning. No depth in the Treasury market (annual turnover is less than half what it was pre-crisis), a duration mismatched powder keg in "long-term" mutual funds thanks to the fact that ZIRP has destroyed money market yields causing investors to find a new 'cash substitute,' and a magically shrinking repo market in the wake of new regulations ironically meant to promote stability.