Illusory liquidity and other risks from misguided central bank policy

Does liquidity matter? Not, it seems, to regulators and central banks. Little thought is being given to the global systemic risk created by today’s liquidity illusion. In a world awash with money, trading is actually drying up, with little depth in many markets. Entering positions is easy, but the exit doors could prove surprisingly narrow. The next financial crisis may be triggered by the very policies regulators are applying now.

Quantitative easing has boosted investment not only in bonds but in exchange traded funds, money market funds, initial public offerings and mutual funds. The primary markets are wide open. But in a crisis, withdrawing funds may be a challenge. Trading volumes have not kept pace with a surge in debt issuance. Turnover in corporate credit has almost halved since the crisis. Policy after the financial crisis was meant to cut back the financial sector’s disproportionate influence, but instead investors’ links with stock markets have been deepened.

Printing money was meant to raise capital expenditure and real investment, improving productivity, but has merely boosted financial assets. Deposits have simply been flushed into shares, bonds and funds, but largely escaped the real economy. Low interest in market-making not only means trading dries up after an initial investment, but there is little incentive for research or consistent price formation. Market prices can easily lose touch with reality when dealings disappear. Much regulation is now driven by market value, but there is less confidence in prices.

Increased underlying investor uncertainty about fundamental values creates fertile ground for flash crashes. Superficially, volatility appears to have been dampened by loose monetary policies and massive central banks’ purchases of bonds. But it puts monetary policy in centre stage, driving correlated moves in all financial instruments. Even traditionally liquid markets, such as foreign exchange, are linked to these patterns. The greater frequency of these air pockets in markets – often without obvious cause – should worry central banks.

Given negligible or negative returns on cash, there is little incentive for investors or financial institutions to maintain any liquidity buffer. And regulators have discouraged investment banks from holding inventory of shares and bonds to assist market making. Regulations have driven up the cost of banks’ balance sheets, and reduced their appetite for risk. In the US, banks have cut trading securities to less than 15% of total earning assets, down from over 20% in 2008. In the EU, the figure is now less than 12%. Leverage ratios, liquidity coverage and Basel capital rules have all taken their toll on the ability of banks to help in a sell-off.

Certainly, some indicators, such as average bid-ask spreads, do not suggest less liquid markets. But overall activity levels and sharp extreme market moves point to the risks. The Bank of International Settlements – the bank for central banks – has voiced its concern on the rising danger. The problem may be particularly acute in bond markets. Traditionally, fixed income mutual funds and ETFs have been seen as sources of market liquidity in time of stress. In normal markets, ETFs offer intraday liquidity. But this may be false comfort in a crisis: liquidity is always there until it is not.

The investor base of bond ownership has been changing, with banks no longer as influential in credit markets. More bonds are now held in mutual funds; bond funds have had $3 trillion of investor inflows globally since 2009, dominated by corporate bonds. But in most corporate bond markets, trading is now concentrated in relatively few liquid issues. Indeed the most liquid include bonds issued by banks, and these are likely to be the ones at the front end of any panic selling. The structure of the bond market may actually be increasing systemic risk.

A number of asset classes appear to offer more liquidity than their underlying constituents; ETFs, futures and indices. ETF trading now represents almost 30% of the value of all US equities traded. In Europe more of this activity now comes in end-of-day auctions, rather than evenly through the day. And although e-trading appears to boost day-to-day liquidity, this primarily benefits small trades – larger ones are much harder to clear.

We have moved from an over-banked world to one with too little intermediation. The result is a more tightly coupled financial system, with costs driving out the slack that can help in market panics. Regulators and central banks do not seem to want responsibility for ensuring sufficient lubrication in the system, when investors may want to stampede for the exit. Nor would locking-in investors in a crisis – in some form of gating or capital controls – do much to stabilise markets. Asset managers are expected to warn clients of liquidity risks, but the tools to manage the system are in the hands of regulators and central banks.

So determined are politicians and regulators to drive down financial intermediation costs, the key role of liquidity and price setting is being overlooked. Turnover may once have been too high in some areas of the market, but there seems no official policy on what the right level of market activity should be. It often takes the summer months, with a further seasonal drop in trading, to highlight the danger. The very lack of company news in July and August gives centre stage to geo-political developments and sovereign risks. The test to liquidity may come when markets are least able to cope.

Markets work best with a diversity of participants and views. Now, markets are distorted, with investors herded in the same direction by central bank policy. But one-way markets and cash flows can change direction overnight. Regulation and misguided policy is laying the foundation for the next crisis.

A version of this article was published as an Op-Ed in Financial News on July 6th 2015.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. I have no business relationship with any company mentioned in this article. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

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