Global liquidity under pressure
by Ben Robinson
Global liquidity – a vital ingredient in the factors driving markets and growth worldwide – has been under severe strain in the eight years since the financial crisis. This is underlined by periodic disruption in even the most liquid market of sovereign bonds, as well as limits on some fund redemptions and less frequent trades and lower turnover for some assets. As an OMFIF report published on 11 October demonstrates, global public investment institutions have contributed to this situation, but sovereigns show a growing willingness to play a role in mitigating the challenges.
Low interest rates from central banks led to an expansion of high-yield and ‘junk’ bond issuance, while large public purchases of safe and liquid assets reduced yields for investors, pushing them towards these riskier assets.
A second cause of lower liquidity – the tightening of banking regulations which have raised the cost of balance sheet-intensive activities such as market-making – has meant banks have become less able and less willing to stabilise markets. In the past, banks and securities firms helped smooth the market when an immediate buyer or seller could not be found, by using their balance sheet to become the counterparty to trades. However since 2008 they have lowered their inventories by over 80%, reducing their ability to play a stabilising role.
The result is a large growth in primary market issuance despite a lack of secondary market depth, making assets vulnerable to rapid price corrections when monetary policy or market sentiment changes. The speed with which this may happen has increased as market participants have changed, including the growth of ‘shadow banking’ institutions, mutual funds and high-frequency traders, adding to complexity over counterparty risks and trade strategies.
The dangers are substantial. If liquidity in financial markets and the ability of corporate and sovereign bond issuers to raise funds at affordable prices are reduced, second round effects could emerge which set off a series of bankruptcies and insolvencies.
As seen after the financial crisis, when trust in financial markets evaporates, along with confidence in the quality of assets and the ready availability of funds on which liquidity depends, the reverberations can be deep and long-lasting.
The prospect of divergent monetary policy between different central banks brings these risks to the fore, as many emerging economies are highly leveraged, many mutual funds offer open-ended daily redemptions, and large amounts of post-crisis debt issuance remain outstanding. Future US rate hikes risk asset price deflation, a decline in new issuance and an increase in short positions.
In this context, compensating for the lack of liquidity-enhancing but balance sheet-intensive activities of banks, stabilising markets to prevent investor runs, and ensuring access to wholesale market funding are vital to avoiding a liquidity shock. As underlined by an OMFIF survey of sovereign institutions with $4.74tn in assets under management, sovereigns are willing to meet these challenges, particularly via increased capital markets activities such as securities lending and direct funding of less-liquid asset classes including private debt and equity.
Among other palliatives, sovereign investors suggest widening collateral eligibility for repo transactions, increasing sovereign participation in wholesale funding markets, ‘renting’ their balance sheets, and directly funding some assets and projects to offset some of the issues of bank disintermediation.
Obstacles to overcome
Obstacles need to be overcome, however, including regulations on banks and dealers, a lack of coordination between regulators and sovereigns, and a lack of coordination among sovereigns themselves.
Some GPIs need to overcome internal rules that prevent them from pursuing a more active role in securities lending or repo markets. They need to manage the implied counterparty, credit, collateral and cash collateral reinvestment risk involved in these expanded activities.
Reforms to market infrastructure and practices can offset some of these
challenges, including via better collateral valuation rules and margining policies, as well as increased counterparty risk management. The tri-party repo reform in the US, and the European Markets Infrastructure Regulation which places a central clearing counterparty between traders, have helped to tackle some of these concerns. They have, however, raised costs and increased demand for high quality collateral. This raises the importance of collateral management and reuse facilities from custody banks.
Scope for sovereign involvement
The desirable level of sovereign institutions’ involvement in capital markets is contested, with some survey respondents arguing that it is not the role of official institutions to price risk or make markets, and should instead act as asset managers with a long-term view. However more than 40% of institutions believe there is an increased capital markets role for sovereigns as a result of bank disintermediation.
The potential benefits are significant: not just an increase in market liquidity and resilience to destabilising shocks, but also the rewards of higher yields to offset the disbenefits of low or negative interest rates on high-quality liquid assets.
Ben Robinson is Economist at OMFIF. This is an edited version of ‘Mastering flows, strengthening markets: how sovereign institutions can enhance global liquidity‘. For a copy of the report, please contact email@example.com. Back