Samuel Taylor Coleridge’s Ancient Mariner captured the paradox of scarcity amidst plenty: “Water, water, everywhere, nor any drop to drink”. In a curious parallel, financial markets are concerned about the lack of trading liquidity despite the actions of central banks to maintain a seemingly unlimited supply of money.
All trading liquidity relies on dealers willing to warehouse securities (by purchasing securities that end investors want to sell), manage the risk assumed and resell the position later. But the market-making capacity of dealers has contracted sharply, especially in bonds but also in other financial assets.
In the US Treasury bond market, major dealers had a capacity of about $2.5-3trn to make markets in 2007. Today that amount has fallen by over a third. Europe shows a similar pattern. And this despite a big expansion in the underlying markets.
The reduction is driven by risk aversion as banks reduce trading activities, with many now focusing on core, often domestic, markets and fewer, major clients.
The change also reflects regulatory initiatives. Banks have been required to reduce risk, strengthen capital and balance sheets and funding. This has made it more expensive and less attractive for banks to make markets for clients. The Volcker Rule in the US has restricted banks engaging in proprietary trading, which traditionally has assisted market liquidity and reallocated risk.
These measures, which are likely to become more stringent, may have improved the resilience of financial institutions – but at the expense of trading liquidity. And they have coincided with rising demand for market-making services as the size of securities markets increases.
The combination of these factors mea precipitate ns trading has become more dependent on a few large institutions, and liquidating positions may prove increasingly difficult. Lower supply and increased demand for market-making will ultimately reduce trading liquidity and raise trading costs, in turn pushing up financing costs and lowering investment returns.
Reductions in trading liquidity can generate greater price volatility. Increasingly, markets are characterised by generally low day-to-day volatility but more frequent, large price changes. In October 2014, US government bonds rates moved 0.40 per cent in a few minutes. In early 2015, German government bond yields rose from near zero to 0.80 per cent in a few days. Statistically, these are price changes which should only occur once in several billion years.
Of more concern is the ability of financial markets to absorb stress. The absence of trading liquidity may not cause the next financial crisis but it will inevitably increase volatility and accentuate losses. The inability of dealers to expand their balance sheets in an elastic manner to buy cheap assets and warehouse them will, at a minimum, exaggerate price fluctuations. If the shocks are large, then it is not inconceivable that markets will become disorderly or cease to function.
The Bank of International Settlements has warned that markets are increasingly fragile and recommended that market participants and relevant authorities should work to correct the illusion of liquidity. But unsurprisingly there are few signs that these warnings have been heeded.
The problems of liquidity highlight the distorting effects of intervention. Official policies in the aftermath of the financial crisis have forced excessive risk taking in search of returns. At the same time, regulatory changes have contributed to a reduction in trading liquidity. Over time, the process feeds on itself with investors becoming increasingly exposed to ever more risky financial assets which will become illiquid in a crisis, triggering a price collapse.
The process is difficult to reverse. Withdrawal of liquidity would precipitate the problems. Yet the more money that central banks add to the money markets, and the longer they delay in withdrawing their support, the greater the distortion to normal market functioning and the larger the risk. It may even become impossible to exit at all without setting off major crisis.
There is a significant risk that in the next crisis central banks will be unable to avoid having to step in as buyers of first and last resort, to prevent disorderly markets and undesirable levels of volatility. This will entail, once again, the commitment of taxpayer funds to support the financial system.
Coleridge’s poem is often interpreted as exploring a violation of nature and its effects. Today, excessive liquidity is increasingly a violation of normal market operations. Liquidity provided by central banks is increasingly like the mariner’s albatross, a barrier to exiting the policies which have failed to restore the health of financial markets and economies globally.
Satyajit Das is a former banker. His latest book, ‘A Banquet of Consequence’, will be released internationally in February 2016
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