With a US rate rise round the corner capital markets could get worse before they get better, they said — echoing warnings from the IMF and the Institute of International Finance (IIF).
Hung Tran, executive managing director at the IIF, said the combination of central banks pumping in money and structural and regulatory changes had left international securities markets “untested” in times of crisis.
Senior investment bankers saw little reason for optimism. “It should not be a surprise that in the past year we have not seen any significant change in banks’ approaches to providing liquidity to the secondary market,” said Paul Tregidgo, vice-chairman of DCM at Credit Suisse.
“A very clear message was delivered to derisk and become safer, and — whether intended or not — we have to deal with the consequences.
“I am not sure we have seen a solution emerge yet. Meanwhile, the higher cost of risk transfer will work its way through the system and impact pricing along the chain.”
Although portfolio managers have been complaining for some years about the lack of liquidity that banks’ inability to make markets has caused — particularly in high yield and EM bonds — the IMF’s latest financial stability report suggested that a rise in US rates would make the problem more acute.
“Benign cyclical conditions are masking liquidity risks,” said the report, stating that cyclical factors were among the most important drivers of liquidity.
Many of these cyclical determinants — investor risk appetite, and macroeconomic and monetary policy conditions — were aiding liquidity.
Last night Agustín Carstens, the chair of the Fund’s international financial and monetary committee, warned that higher US rates could “lead to asset price adjustments and to market illiquidity”.
He said authorities should be “made aware of the fact that lack of liquidity might be present and also it is important to warn markets that such a situation might arise”.
REGULATORY IMPACT
With some regulation yet to be implemented, the picture could be even bleaker.
“With Mifid II on the way, the dynamic of thin secondary market liquidity is only going to become more challenging, and the volatility it creates will only exacerbate negative moves,” said Spencer Lake, global head of capital financing at HSBC. “Although risks are still being absorbed in primary markets, borrowing costs could go up as a result.”
The concern is not just theoretical, nor restricted to fixed income markets. The IIF’s Tran pointed to the incident on the New York Stock Exchange in August when the prices of some blue chip companies crashed by 20% within five minutes of opening.
The issue of what causes market liquidity to evaporate are becoming better understood “but the root causes of flash crashes is something no one understands”, he told Emerging Markets.
EM, HY FEARS
Nevertheless, the IMF highlighted EM and high yield bonds as most vulnerable to illiquidity, and Société Générale’s group chief economist, Olivier Garnier, said that even peripheral debt in the eurozone has been resilient at the same time as volatility had hit EM.
“In emerging market debt you don’t have the equivalent of the ECB to act as the buyer of first resort,” said Garnier. That is not to say that developed markets are immune from these issues, and liquidity is lower across the board.
Garnier said “the impact of a sell-off could be much more dramatic than expected due to herding behaviour — the fact that no one would be ready to buy, even at discount prices. There’s also a contagion risk: investors would have to sell other assets to finance losses if in emerging market debt.”
Some debt capital market participants have expressed hope that institutional investors may step into the breach. But none has appeared, and Solvency II means it is harder for insurance companies, at least, to add risk during sell-offs.
“New regulations are making investors that would normally buy when prices are low more pro-cyclical,” said Garnier. “It is reducing their ability to take long-term risk.”