The Bank for International Settlements (BIS) released its quarterly review earlier this week, which included a discussion on the acute volatility and “evaporating liquidity” during the German “bund tantrum” in May and June of this year.
It was a period of concerns over Greece and future of the euro and the BIS said “daily maximum and minimum prices, was higher in June 2015 than during any other period over the past four years. Intraday volatility measures indicate even higher stress levels.”
But Bunds aren’t the only markets which are dislocating and experiencing lost liquidity or even ‘flash crashes’. Back in July gold lost 4% in a matter of seconds during Asian trade, while in the Dow was down as much as 1,189 points from the open of trade on August 24.
Understanding this increased volatility and these much larger than usual moves is something traders, investors and global regulators are trying hard to get their arms around.
In a speech this morning to the Actuaries Institute ‘Banking on Change’ seminar, RBA assistant governor Guy Debelle neatly explained why global markets are so prone to these types of short-term funks and why they will continue.
Essentially he says that the key players, at least in the bond markets he is talking about, are no longer prepared to “warehouse” risk and as such no longer act as a circuit breaker when a market dislocates.
In terms of technology, there has been a significant increase in the share of electronic trading in bond markets. In the Australian market, we estimate that electronic trading accounts for around one-third of trading in the Australian government securities market (though it is considerably less in other domestic bond markets).
In the US, the share of electronic trading is much higher, more than half of turnover. With the increased electronification of the market has come high-frequency trading firms. These firms are providing increased liquidity at the top of the book, but are not necessarily contributing to the depth of the book, given their preference to trade in small size, as well as in many cases, inability to trade in large size because of balance sheet constraints.
They have contributed to lower transaction costs (in terms of the bid-ask spread) for small orders. But there are question marks around their resilience in times of market stress. The key structural change is the shift in market share from those who provide immediate and continuous liquidity and have the ability to warehouse risk to those who do the same but don’t have the capacity to warehouse risk.
In a telling comment on the impact of electronic trading platforms and HFT firms Debelle said bonds had moved down the “well-trodden path of the equity and later the foreign exchange market” and noted that not all would regard this move “as a good thing”.
But Debelle noted that regulators had some responsibility in the decline in liquidity and increased volatility.
Regulatory changes have increased the cost to banks of intermediation, and hence liquidity provision, in many markets, and particularly the bond market. This has seen a number of participants withdraw completely and others scale back their activities. Bond desks at banks hold less inventory than they have done historically, given the increased cost of doing so. This contributes to less ‘depth of book’ liquidity, though not necessarily less ‘top of book’ liquidity.
The regulatory changes were intended to have this effect. Liquidity provision was under-priced previously and was over-supplied.
That’s not to say he doesn’t also highlight the responsibility investors and money managers must accept by taking into account the costs and available liquidity when constructing their portfolios.
But in the end he circled back to the banks, the previously solid providers of market liquidity, as why the markets have changed.
I think the issue is not so much one of a decline in liquidity as much as a decline in the capacity to warehouse risk. In the past, when there was a large sell-off in bond markets, liquidity was never that great. A bank has no more desire than any other investor to catch a falling knife. Bid-ask spreads widen considerably and the depth of book deteriorates. That has always been the case.
However, in addition to a decline in liquidity provision, banks now have less risk-warehousing capacity than they did in the past. They are less able to be nimble buyers of assets whose prices they believe have overshot. In the past, while the banks may have pulled back for a while as prices fell, they were generally among the first to step in and buy when they felt that the price had overshot. This is one important aspect of what I mean by warehousing or absorbing risk. As a result of regulatory changes as well as their own risk tolerances, they are less willing and able to do this today.
As a result Debelle says markets are going to have to get used to the reality that “prices will move by larger amounts and remain away from equilibrium values for longer. Volatility will be higher. In itself, this is not necessarily a bad thing. It is what it is.
“But with higher volatility, the distribution of price movements will have fatter tails. Overshooting will be more likely and that can have long-lasting and more deleterious consequences.”
That’s an important message traders and money managers need to understand. It seems volatility is the new black.
The speech is here.
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