A smoking gun on liquidity
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A smoking gun on liquidity

Chin-stroking academic studies have mostly failed to find evidence of the ‘liquidity crunch’ which investors and traders alike say has taken hold of bond markets in the wake of tougher regulation. Now that looks to be changing.

The Bank for International Settlements, in its quarterly update, mostly delivered the standard regulatory/academic line on liquidity, in its study of it in the immediate aftermath of the UK's June 23 referendum on EU membership.

“Before the UK referendum, many observers voiced concerns about whether markets would be resilient to an unexpected outcome,” said the study. “After the event, in core fixed income markets, and indeed most other markets, it was evident that the system was able to smoothly absorb the brief turbulence that followed. Markets went through the Brexit vote with little or no disruption to functioning.”

That has some intuitive truth to it — in their second quarter results, several investment chiefs praised the two-way flows around Brexit, noting that it had delivered excellent trading volumes and rounded off a strong quarter, particularly for firms with a strong rates and FX franchise.

But Brexit was a very particular set of circumstances. It was a disruptive event — but one with a long lead time, allowing banks to go into the vote with flat inventories, dedicated balance sheet, and plenty of staff on hand. It also generated flows in both directions.

Enough investors saw a buying opportunity that banks weren’t trying to stand in the way of a market rout — they were standing in the middle of a major repositioning.

The BIS study also focused on a few, fairly misleading indicators. Because of the paucity of price and market depth data in the more exotic areas of fixed income, the measures it uses — bid-ask spread, quoted depth, and average transaction size — focused overwhelmingly on the most liquid products.

Bid-ask, for example, used 10 year govvies from the UK, Germany, Italy and Japan. Quoted depth looked at on-the-run two year US Treasuries and BTPs, while average transaction size added Spanish public debt to those two asset classes.

Talking to investors about liquidity, one rarely gets the impression that these are the assets they’re worried about.

Another chart in same report tells a different tale. 

BIS economists in a later section looked at how banks have found it harder and harder to arbitrage away cross-currency basis spreads, finding that “since 2014 the basis has started to exhibit quarter-end spikes, along with repo rates, indicating that arbitrage has become harder. This has coincided with the greater importance attached to quarter-end reporting and regulatory ratios following regulatory reforms.”

The Basel III leverage ratio, likely the greatest constraint on products like repo, vanilla interest rate swaps, and government bond holdings, only has to be reported at quarter-end. European regulators passed rules requiring a monthly average instead — but didn’t apply it until December 2017.

French firms, which are taking advantage of the exception, have reportedly taken a larger share of the repo market, even in the US, while the US-headquartered firms, hamstrung by a quarter-average reporting, already in place for US-regulated firms, have pulled back.

That leaves big rate spikes in US-Japanese repo rates at quarter-end, generated as firms primp and preen their balance sheets for regulators and investors. There have always been some quarter-end effects, but now leverage regulation is the binding constraint, the problem has ballooned.

A failure to close an arbitrage — to book risk-free profit — is not likely to move many people to the barricades in favour of easier regulation for the big trading banks. But it’s a firm, tangible sign that the market is not functioning properly, and, over time, is corrosive to an integrated, global capital market. If regulators need proof that regulation hurts trading, it’s already in their hands.


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