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.