Right now, people in markets are worried about one big thing: liquidity.
But there’s a problem: no one is exactly sure how to define or measure it.
This week, Peter Hooper and his team at Deutsche Bank wrote a big report dissecting the subject of liquidity and defined it — or tried to — as follows:
What do we mean by market liquidity? Although there are potentially many different definitions of market liquidity, in its simplest form we think of a liquid market as one in which trades can be executed with some immediacy at low transaction costs. But even within this short and simple definition there are many uncertainties: Does this refer to all trades, regardless of size, or only trades of a “normal” size? What constitutes a low transaction cost, and how do we best measure this? Because of these uncertainties, there is no single best metric for the level of liquidity in a market.
Since the bond market’s “flash crash” back in October — when US 10-year Treasury yields fell 34 basis points, or 0.34% in one morning — concerns regarding liquidity and how resilient the bond market might be to shocks have lingered around the market. In the Minutes from the Fed’s January policy meeting, we noted that the Fed was clearly starting to worry about liquidity.
In late March, Oaktree Capital’s Howard Marks captured the zeitgeist when he wrote a note to clients dissecting the topic. Marks arrived at more or less the same definition of liquidity as Hooper, writing that the way to think about liquidity isn’t to ask if there is a market for an asset, but whether you can quickly sell that an asset without taking a huge loss on it.
“It’s often a mistake to say a particular asset is either liquid or illiquid,” Marks wrote. “Usually an asset isn’t ‘liquid’ or ‘illiquid’ by its nature. Liquidity is ephemeral: it can come and go.”
How liquidity disappeared
Earlier this month, Hooper’s colleague Torsten Sløk sent around a chartbook all about the topic of liquidity, and many of Slok’s charts appeared in Hooper’s note published this week.
Near the top of Sløk’s book was this chart showing bond market volatility rising while the number of bond market transactions has only ticked up modestly. This, in short, illustrates the problem that low liquidity environments can create for market participants: each transaction causes a bigger and bigger ripple in the market.
As for why liquidity seems to have dried up so much, Deutsche Bank has a few theories.
For one there are regulatory changes. Deutsche Bank notes that, “since the crisis related to banks’ capital and liquidity have affected the size and composition of banks’ balance sheets. One net result of these reforms — and there are certainly many others — has thus far been for banks to hold less Treasury securities and corporate bonds.” And so if banks are holding fewer bonds, they have fewer ways to post collateral and potentially fewer ways to finance transactions.
The firm also notes that a recent report from the New York Fed, which we wrote about here, discusses the role that electronic and automated trading could be playing in the bond market, particularly how these dynamics may have exacerbated the bond “flash crash,” an event JPMorgan CEO Jamie Dimon said is the kind of thing that happens “once every 3 billion years or so.”
But these are what we would call “exogenous” factors, or things outside the bond market’s direct purview that influence the market’s behaviour.
Deutsche Bank also thinks there are also potentially endogenous factors, or factors directly inside the market, weighing on the bond market’s behaviour.
From Deutsche Bank:
Shifts in liquidity might not only be the result of exogenous factors but may also be an endogenous response to the macroeconomic environment. The asymmetry of prospective rate moves in different parts of the curve with short rates at the zero lower bound, explicit forward guidance about future policy decisions and massive asset purchase programs may result in a higher likelihood of one-sided markets, which may in turn impair liquidity, or at least lead one to conclude from liquidity indicators that markets have become more illiquid.
Measuring the decline of liquidity
The problem with liquidity isn’t just that we have a hard time pinning down a definition, but also have a hard time measuring its presence or absence in the market.
This chart from Deutsche Bank is the firm’s best effort at capturing how we can measure liquidity. The chart shows the number of transactions in Treasury bonds divided by the MOVE index, or Merrill Lynch Option Volatility Estimate which measures Treasury market volatility.
Again, if lower volume creates a bigger change in the market, this is reflecting a decrease in market liquidity.
Still, Deutsche Bank finds this chart unsatisfying.
“We emphasise, however, that it is unclear the direction of causality in this metric,” Hopper and his team note.
“Is it that lower liquidity is causing volatility to be higher for any given amount of trading activity? Or is it the case that spikes in volatility cause reductions in trading volume? Regardless, the fact that this metric has fallen into the lower range of readings over the past ten years — outside of the very low readings during the crisis — suggests that recent movements in volatility have come amid relatively subdued trading volumes.”
It seems that now, it takes less to do more in the bond market.
Why liquidity matters
In his March note to investors, Marks admits that when he set out to write about liquidity, he didn’t believe the topic was all that interesting or profound; in the month since Marks wrote the piece, it has been the market’s chief concern.
The ghosts of the financial crisis are a reminder that liquidity may be the kind of thing that seems mundane during times of financial calm, but is in fact the crux of what panics and crises are all about.
I started this memo by saying liquidity might not be a profound topic. But when I ran a draft by our CEO Jay Wintrob, who came to us in November from AIG, he took issue. I’ll give him the last word:
In September 2008, AIG experienced serious liquidity issues (despite its $US1 trillion balance sheet) when it couldn’t post $US20-25 billion of liquid collateral related to credit default swap contracts written by one of its subsidiaries. The U.S. government stepped in as a result, lending support that eventually reached $US182.3 billion, massively diluting AIG shareholders in the process. When you can’t meet a margin call because you have insufficient liquidity, that’s profound.
And so of course no one is sure how the market will react when the Fed raises rates, or what happens if there is another event that causes credit markets to seize up. But there is growing concern that markets look fragile and that there is an increasing risk that something — whatever that is — goes wrong.