Center for Financial Innovation and Stability

Notes from the Vault

Larry D. Wall
May 2016

This Notes from the Vault post discusses three takeaways from the recent Atlanta Fed conference Getting a Grip on Liquidity: Markets, Institutions, and Central Banks: (a) liquidity measures are improving but the concept remains slippery, (b) regulation is an important determinant of market and institutional liquidity, and (c) technology has and will continue to drive substantial changes in the provision of liquidity. In a separate commentary, Atlanta Fed Vice President Paula Tkac provides some thoughts on central bank liquidity provision.

Improving liquidity measures
Liquidity is a slippery concept because it is used in different contexts to mean different things. Federal Reserve Bank of New York President William C. Dudley began the conference with a keynote speech in which he distinguished between market and funding liquidity. He defined market liquidity as the cost in expense and time of buying or selling an asset for cash. This type of liquidity is important to investors and to financial institutions. However, it is also important to those raising funds, as investors will pay more for securities that have more market liquidity. In contrast, funding liquidity is the ability of a financial institution to raise cash by borrowing. This is important to financial institutions and those holding claims on financial firms.

University of Maryland Professor Albert "Pete" Kyle presented a paper on measuring market liquidity that sought to collapse the time and cost of selling an asset into a single measure. He finds that by his measure individual corporate bonds are approximately 55 times less liquid than on-the-run Treasury securities. His measure can also be used to estimate the losses from "fire sales," that is, the forced selling of an asset over a short time period. Finally, he observes that the cost of funding liquidity in the form of secured borrowing (such as repurchase agreements or "repos") should be correlated with his illiquidity measure, as it is a measure of risk to the lender if the borrower does not repay the debt and the security needs to be sold. Thus, his measure could be used to compare the cost of various sources of funding liquidity in order to optimize liquidity risk management within institutions.

Funding liquidity becomes important when a financial entity issues claims that can be redeemed before its assets mature. Whether and how the entity can manage the risk of such redemptions, and the consequences of such redemption, depend upon the entity.

In the case of banks and others entities that issue liabilities in their own names, the risk is that the entity will face a run—existing liability holders will demand redemption and other potential lenders will not offer replacement funding. This risk proved to be a major problem during the financial crisis, leading to the collapse of Bear Stearns and Lehman Brothers in the United States and Northern Rock in the United Kingdom (UK) along with the near collapse of a number of other financial firms. Since the crisis, bank supervisors have set new minimum standards of liquidity risk for banks, according to Jai Sooklal, a Oliver Wyman partner. Sooklal explained how these requirements rely on more sophisticated measures of market and funding risk than had existed prior to the crisis.

Runs on money market mutual funds were also a major problem after Lehman's failure. Although new regulations seek to address these concerns, attention has increasingly turned to the risk of runs on other mutual funds, especially funds specializing in corporate bonds and high-yield bonds, in particular. The concern here is not that the mutual fund would fail, as any losses would be passed on to the fund's shareholders. Rather, the concern is that massive redemptions in a large number of bond mutual funds could trigger forced sales by these funds that would depress prices in these relatively illiquid markets, resulting in losses and possibly financial distress at other bond investors.

An academic paper presented by University of Pennsylvania Professor Itay Goldstein observes that bond fund investors typically receive the net asset value as of the day they withdraw their funds even though the fund may subsequently have to sell its bonds at a discount in illiquid markets to honor the withdrawal. He argues that this creates a first-mover advantage, in which investors in poorly performing bond funds are encouraged to withdraw their funds early before their fund's value is depressed by forced sales. His empirical analysis finds that the flows out of individual bond funds were more sensitive to poor performance than equities and that this sensitivity increases as the fund's investments become more illiquid.

How bond mutual funds manage this illiquidity risk was part of Gregory McGreevey's discussion of Kyle's paper earlier in the day.¹ McGreevey, the chief executive officer of Invesco Fixed Income, explained that mutual funds recognize liquidity risk as an important issue for their investors and they actively manage this risk. This includes holding cash buffers, buffers that have proven to be sufficient to cover net withdrawals almost all of the time. Additional tools that mutual funds could use to manage the potential impact of redemptions in mutual funds include in-kind redemptions and swing pricing, according to Barbara Novick, vice chairman of BlackRock Inc.

In discussing Goldstein's paper, Sean Collins, a senior director at the Investment Company Institute, more directly addressed the risk that aggregate net outflows from bond funds could result in significant declines in bond prices. He found that the historical evidence on aggregate bond fund flows does not provide a reason for concern. In many instances, outflows from particular bond funds end up as inflows into other bond funds, retaining investment dollars within the sector. In addition, while there have been episodes of poor performance in the bond sector, these have not historically led to large wide-scale redemptions. In a postconference response to Collins, Goldstein affirms his concern that, while massive redemptions have not occurred, this does not rule out the possibility that they could manifest in the future.

Impact of regulation on liquidity
Although some skeptics like to think of financial markets as analogous to the "wild west" with few rules, in fact, the structure of financial markets is subject to considerable regulation. Moreover, these regulations have significant impact on the provision of liquidity in financial markets. Carnegie Mellon Professor Chester Spatt presented a paper in which he highlighted the ways in which liquidity in equity markets has been affected by regulation. For example, the Security and Exchange Commission's (SEC) regulation NMS (National Market System), which prevents "trade through" of equity orders at a less favorable price available in other markets, has led to fragmentation of the equity markets and encouraged a shift in trading from exchange floors to electronic markets.

Changes in the liquidity of bond markets due to changes in the regulation of bond dealers has been the subject of considerable concern. Most of the large bond dealers in the United States are now subject to bank capital and liquidity standards, and are also subject to the ban on proprietary trading in the Volcker rule. These regulatory changes could adversely affect dealers' incentives to provide liquidity to bond markets.

Dudley's and McGreevey's presentations both observed that the evidence that these regulatory changes caused a decline in bond market liquidity is mixed and that any differences could also be due in part to other changes in the bond market. Novick suggested that in part the apparent decline in bond market liquidity is due to the common use of reporting a decline in the ratio of number of transactions to bonds outstanding. Contrary to what is sometimes implied, the number of transactions has gone up, but just not as fast as bond issuance. Nevertheless, no one denied that dealers play a smaller role now than they did precrisis, with Dudley observing this may be a "small price to pay" for a more stable financial system.

There is also growing concern about liquidity in European markets. Jeffrey Tessler, a member of the executive board of Deutsch Börse AG, noted that the organization has observed dealer risk tolerance in cash and derivatives markets has "notably declined." He attributes this in part to similar capital regulations in Europe and the ring-fencing of retail banking in the UK. Tessler also said he expects the situation to become worse as Europe adopts MIFID II, which will apply the bank-like prudential capital requirements to a wide variety of investment firms.

The solution to reduced dealer liquidity advocated by some is simply to roll back some of the regulation of bond market participants, including dealers. However, other regulatory change alternatives were suggested by several speakers. Seth Merrin, chief executive officer of Liquidnet, argued that regulators should stop making incremental changes in the regulation of equity and bond markets, and instead craft regulations designed to take full account of changes in market technology. Jamil Nazarali, head of Citadel Execution Services, discussed several changes that would be helpful for the foreign exchange and derivatives markets, including making sure that they are electronic, a central market exists, and transactions are cleared through a central counterparty to alleviate concerns about the credit risk associated with transacting with smaller counterparties.

Both Dudley and Tessler also referenced the potential benefits of allowing nonbank firms expanded access to central banks. Dudley expressed an interest in considering giving securities dealers affiliated access to the discount window (at least if those dealers are affiliated with banks). Tessler touted the benefits of allowing central counterparties to have access to central bank facilities.

Switching to funding liquidity, the relationship of funding liquidity and market liquidity has long been a concern of financial intermediaries and their supervisors. Sooklal talked about the advances in bank liquidity management. However, he also observed that current industry practice is largely being driven by regulatory requirements.² McGreevey briefly mentioned proposed changes in SEC regulation of mutual funds, arguing that it could cause unintended consequences, such as encouraging the offering of multisector funds in preference to more narrowly focused funds.

The intersection of market and funding liquidity with regulation was raised by the presentation of a paper by Charles M. Kahn on the rehypothecation of securities. The use of securities as collateral for loans is a common way for securities investors and dealers to obtain funding. In some cases, the same security may be used as collateral in a series of back-to-back transactions called a rehypothecation chain. Some observers view this as a risky practice that should be severely curtailed or eliminated by regulation. Kahn's paper shows that rehypothecation can be beneficial because it allows scarce collateral to get used in more than one transaction. However, it can be costly if one of the borrowers defaults, as that means the collateral won't get back to its original owner, the party that presumably places the highest value on the security. Phil Prince, managing director, head of Treasury at Pine River Capital Management, discussed how market participants use rehypothecation in practice and suggested some generalizations of the model that would increase its applicability for assessing potential regulatory proposals.

Impact of technology on liquidity
Rapid advances have and are dramatically reshaping large parts of the economic system, including the measurement and provision of liquidity. Mani Mahjouri, the chief investment officer at Tradeworx, observed that today's equity markets would not be possible without the technology that enables the creation of new trading venues and trading activity based on objective rather than subjective factors. For example, trading by people in a physical market meant that individuals knew a great deal about the particular security or derivative they were trading, but it was not possible for them to devote much attention to developments in other markets. Now with electronic markets, it is possible for computers to spot discrepancies in price moves across different securities and make relatively low-risk bets on these discrepancies by going long in one security and short in another.

University of Southern California Professor Lawrence E. (Larry) Harris observed that "the future is arriving" in bond markets with proprietary trading firms replacing traditional dealers and a substantial increase in electronic trading. He noted that half of the bonds in TRACE (Trade Reporting and Compliance Engine) have two-sided quotes almost all the time, and 230 bonds trade more than 20 times per day.

Liquidnet's Seth Merrin uses advanced technology to provide what is called a "dark pool," which allows institutional traders to buy and sell large blocks of stocks with other institutions. Liquidnet has also recently opened a similar technology-driven platform for institutional trading of corporate bonds that could replace a significant fraction of the trading that had been done over the telephone by corporate bond dealers.

Concluding thoughts
Although the concept of liquidity remains a somewhat slippery topic, the recent financial crisis demonstrated that the lack of liquidity in markets and institutions can have a devastating impact on the financial system and the real economy. The recent Financial Markets Conference discussed some improvements that have been made in defining and measuring liquidity. It also highlighted the important role of regulation and technology on the provision of market and funding liquidity. However, much more needs to be done to improve our understanding of liquidity and how it evolves in response to changing market conditions, regulation, and technology.

Larry D. Wall is the executive director of the Center for Financial Innovation and Stability at the Atlanta Fed. The author thanks Paula Tkac for helpful comments. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please email atl.nftv.mailbox@atl.frb.org.

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¹ McGreevey did not use presentation notes, but provided a paper by Tony Wong, Mark Gilley, and Justo Gonzalez from his staff that elaborates on some of the points made in his presentation.

² That could have unfortunate consequences if there is a flaw in the regulatory model, as that flaw is likely to affect (almost) all of the banks around the same time.