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It feels like a long time since we last had a proper bond market liquidity freakout. For anyone hankering for their fix, the International Capital Market Association is out with a new report.
Last year ICMA set up a Bond Market Liquidity Taskforce — which is probably as glamorous as it sounds. The BMLT has now published its first report, examining the health of the “core” European government bond markets, in Germany, France, Italy, Spain and the UK.
Anyone who has followed this debate over the past decade will be unsurprised by ICMA’s “key findings”. Bond market liquidity has become more procyclical as banks retrenched — and is particularly and scarily flighty at times of extreme stress — so regulators should “review” their post-crisis rule books.
• Liquidity in the core European bond markets is generally good, as defined by the ability to execute larger than average transactions, relatively quickly, without significantly moving the market.
• However, in recent years liquidity has become much more sensitive to both episodes of unexpected volatility and regulatory reporting dates (ie year-end and some quarter-ends).
• This can be roundly attributed to the combination of a significant increase in the outstanding stock of government debt while primary dealer balance sheets and appetite for risk, on aggregate, have reduced markedly.
• Applying modelling on historical bid-ask spreads, it becomes clear that at certain points these widen significantly, and this cannot be explained by volatility alone. Rather, volatility is the catalyst for a discernible retreat from liquidity provision.
• Furthermore, the speed at which markets become volatile (the ‘volatility of volatility’) has increased, possibly aided by greater transparency and more dependence on e-trading and automation.
• Repo markets function well, even in times of heightened stress, but are also subject to sharp drops in liquidity around reporting dates.
• Liquidity in the sovereign bond futures markets is generally good, although limited to a few contracts, and again prone to a rapid thinning and widening of prices in times of stress.
• Market participants accept that episodic heightened volatility, with rapid evaporation of liquidity, and a sharp repricing of risk, is the new normal.
• Participants also believe that central banks will be required to intervene in bond markets more frequently and systematically to restore stability.
• The consistent recommendation from market participants, both sell side and buy side, to make sovereign bond markets more resilient, is that policy makers and regulators should review the design and calibration of prudential regulation as it applies to primary dealers. They suggest that there is a trade-off between high levels of bank capitalization and liquidity and bond market resilience.
Basically what everyone in the finance industry has been saying for over a decade, In other words. As well as, to be fair, many central banks, think-tanks, financial regulators and even the IMF. They just think the price of more fickle bond market liquidity is worth paying if it results in a much stronger banking sector.
However, Alphaville still wants to dwell a little on ICMA’s penultimate point, because it touches on an important subject that probably doesn’t get discussed nearly enough (and when it does get discussed it tends to get very emotional, very quickly).
One of the consequences of a financial system where banks are losing ground to shadow banks/non-bank financial institutions/capital markets (delete according to preference) is that the traditional lender-of-last-resort function of central banks will inevitably have to evolve and be widened.
Historically, the focal point of most financial crises has always been banks. Given how disastrous their mass failure can be, central banks therefore almost always (if reluctantly) backstop the industry. But now that markets do more of the heavy lifting, central banks will increasingly have to wade in there to keep the financial system from imploding and damaging the real economy in the process. What was once considered unorthodox monetary policy is now strikingly orthodox.
This was abundantly apparent in March 2020 and 2022’s LDImageddon, even if has never been formally articulated. But as Dan Davies noted on FTAV a couple of years ago, even the BIS — the cathedral of central banking orthodoxy — has floated a new “backstop principle”, which stipulates that:
. . . In situations where it appears likely that market dysfunction will have a material adverse impact on the real economy, central banks should consider using their ability to expand their balance sheets and provide liquidity in order to mitigate this impact.
Quite a lot of central bankers AND market participants are extremely hostile to the idea that being a lender of last resort in the modern era might mean becoming a dealer of last resort.
But as the ICMA report very gently hints, “central bank interventions to stabilise markets [will become] increasingly inevitable and less extraordinary.”
