Everyone is worried about the thing markets need most -- but they're not asking the right questions

Screen Shot 2016 03 18 at 5.00.43 PMNY FedBid-ask spreads – one measure of liquidity – have narrowed, suggesting the bond market is more liquid now than it was pre-crisis.

People are worried about bond market liquidity.

Barely a day goes by without someone adding to the chorus complaining about difficult trading conditions.

Senior figures who have weighed in on the topic in the past couple weeks include former PIMCO chief
Mohamed El-Erian, Federal Reserve Governor Lael Brainard, Mark Heppenstall, chief investment officer of Penn Mutual Asset Management, and Passport Capital investment chief John H. Burbank.

The comments are so common that Matt Levine has a section in his daily email dedicated to detailing Wall Street’s concerns with liquidity. There have even been TV adverts addressing the topic.

But here’s something. A number of researchers have said: “No big deal.”

In a research note out this week, Matteo Aquilina and Felix Suntheim in the chief economist’s department of the Financial Conduct Authority in the UK said there’s nothing to worry about. For example:

On the basis of a series of widely accepted liquidity measures, we document that there is no evidence that liquidity outcomes have deteriorated in the market, despite the decline in inventory of dealers in this period. If anything, the market appears to have become more liquid in recent years.

The findings echo the conclusion of earlier research by the Federal Reserve Bank of New York. In a piece out in February, a team from the research and statistics group looked at various empirical measures of liquidity to see how conditions had changed.

The picture that emerges is one where liquidity may have deteriorated slightly since the pre-crisis period for corporate bonds with the lowest credit ratings but has otherwise improved.

A bunch of Wall Street executives don’t think the market liquidity issues is as big a concern as been made out to be, too.

So what is it? Is the overwhelming anecdotal evidence of changed market conditions incorrect? Have trading conditions actually improved? It depends on where you look, and what you mean by liquidity.

The research that finds liquidity has improved typically focuses on things like bid-ask spreads or the difference the price at which dealers are willing to buy (bid) and the price at which dealers are willing to sell (ask). These have narrowed, suggesting ample liquidity.

Screen Shot 2016 03 18 at 5.05.42 PMDeutsche BankAverage trade size has fallen around 40% from the peak.

Then, there are metrics like price impact,
which gauges how much a bond’s market price changes as the result of a given trade. That too has declined, according to the NY Fed, suggesting more liquidity.
Daily average trading volume for corporate bonds has increased, from around $14 billion before 2008 to around $20 billion over most of 2015, according to Deutsche Bank. The number of daily trades has doubled since the crisis, according to the German bank, in part because electronic trading has increased.

All those metrics could give one reason to believe market liquidity is just fine. Trading volume is up, there are more trades on a daily basis, the trades are having less of an impact on price, and the bid-ask spread is tight.

So what’s up?

Here’s the thing: Most investors care about trading in size and trading when markets are moving dramatically. In both these key areas, markets appear to be in much worse shape.

The average trade size in bonds is down around 40% from the peak in investment grade and high-yield bonds. Deutsche Bank says:

While current bid-offer spreads don’t signal a major malfunction in markets, what matters to large institutional investors is the ability to execute trades in size. Here, prima facie at least, things look a lot worse.

In short, investors want to shift big positions quickly, and when they can’t, they complain about liquidity. There’s an argument that the pre-crisis conditions where they could buy and sell in size with ease wasn’t all that healthy, but that is a topic for another day.

Then, there are the spikes in volatility. You may have noticed that markets have been going haywire far more frequently of late.

That is real. Volatility spikes are happening more often. And when markets go haywire, the liquidity that does exist disappears.

Here’s Deutsche Bank again:

Even if liquidity is decent a lot of the time, the problem is it is effectively non-existent during periods of market stress. In other words, liquidity today is not a continuum of better to not so great. It is binary. It’s either there or it isn’t.

Now, there are a bunch of reasons for this. Regulation has curtailed banks’ ability to take bonds onto their balance sheet during times of market stress and act as a kind of shock absorber. Liquidity providers have stepped in to the gap left behind by broker-dealers — think high-frequency trading firms. But it’s unclear whether they soothe or exacerbate volatility.

All that has coincided with the bond market exploding in size to around $10 trillion, as companies rushed to issue bonds and take advantage of low-interest rates.

The bond market liquidity issue is a complex one, and it often seems that market participants are talking at cross purposes, and/or touting their book. Electronic trading platforms promising to improve liquidity have an incentive to amplify concerns about the issue. Regulators, who many blame for bringing about the change, probably have an incentive to play it down.

So next time you hear someone talk about it, ask yourself: “What are they looking at? And what do they mean by liquidity?”

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