Market liquidity was the second-most cited concern by the 288 respondents to the European Commission’s call for evidence on the negative impacts of post-crisis regulation. A summary of the responses was published on Tuesday.
But the reaction of authorities and regulators to that concern has been a collective shrug. Results of different assessments of bond market liquidity are mixed, they say, largely qualitative, or based on internal assessments that aren’t extractable in any meaningful way.
The worst of the arguments industry professionals make regarding bond market liquidity is that, if it is too much reduced, markets risk being submitted to exaggerated volatility, potentially a greater number of ‘mini-crashes’, perhaps worse real crashes.
Which is broadly nonsense. Equity markets, which nobody disputes are liquid, are also volatile, and even when banks aren’t under the kinds of regulatory constraints that hinder their market making practices, they’ll still avoid catching falling knives as if they were, well, actually falling knives.
A better argument is simply that all parties define liquidity and assess liquidity differently, based on the nature of the relevant asset class, whether it is traded on exchange or OTC, who the primary participants in the secondary market are, the existing infrastructure of the relevant market, and host of other reasons.
It is defined in practice — actual interaction with markets for which it is a relevant concept. Bid-offer spreads, turnover, market depth, market resilience, firm quoting, quotes in size, inventory sizes, number of quotes and transparency all have something to do with it, but no measure captures it completely.
That doesn’t mean it isn’t an important concept, but it is extraordinarily hard to measure in an objective, widely agreed fashion. Even if the authorities had the data to do so.
Steven Maijoor, chair of the European Securities Markets Authority, said at an event in Brussels on Tuesday that authorities were “supervising in the dark in the run-up to the crisis,” having little or no relevant data in various areas with to identify and correct problems.
Maijoor emphasised that much data, particularly on bond market liquidity, is inconclusive or incomplete. (He, and the Commission’s summary paper, complained that many industry concerns involve qualitative analysis of rules not yet implemented, like MiFID II.)
That doesn't mean that authorities should implement rules now, observe their effects over years, and then go back and tweak later.
Improving the functioning of Europe’s capital markets is a top aspiration, with the goal of reducing the continent’s reliance on bank funding, and it's urgent. Regulation, meanwhile, moves at a glacial pace, but can fundamentally and permanently alter markets.
So European authorities, perhaps national supervisors in concert with the European Central Bank, should be engaging capital markets institutions directly in order to synthesizing different measurements into a framework for the idea of liquidity that can be used to inform regulatory decision making.
Not necessarily because we risk worse financial crashes, but because we risk having markets that don’t work properly enough to be fit for purpose. That purpose being European economic stability and growth.
If authorities don’t get to work on the topic, they’ll only be guilty of continuing to supervise in the dark.