21st Annual Financial Markets Conference—Getting a Grip on Liquidity: Markets, Institutions, and Central Banks - May 1–3, 2016
The goal of this event—to synthesize the three perspectives of funding, market, and central bank liquidity and make progress toward "Getting a Grip on Liquidity" (the conference theme)—was particularly ambitious. Although the conference covered a lot of ground in terms of understanding liquidity and its interactions with institutions, markets, and central banks, we are still left with seemingly endless questions that academics, policymakers, and practitioners will delve into.
Below are just a few summaries of some of the conference's broader themes, along with some highlights from the sessions. We encourage you to explore these sections to get a feel for the discussion around some of the questions raised at this year's Financial Markets Conference.
Full-length videos of each session, as well as the associated papers and presentations, are available on the conference agenda page.
Institutions, Markets, and Central Banks
Liquidity is a multifaceted subject. Atlanta Fed President Dennis Lockhart opened the conference by noting that maintaining appropriate levels of liquidity is essential to both the operation of the financial system and the Federal Reserve's mandate of prudently and efficiently carrying out its responsibilities as regulator and lender of last resort. However, simply defining liquidity can seem elusive and depends greatly on whom you ask. To illustrate this point, Cleveland Fed President Loretta Mester at the start of her session listed no fewer than eight separate definitions of liquidity from a poll of just 15 economists. While these definitions are typically collapsed into three broad perspectives (see Paula Tkac's Notes from the Vault for a detailed discussion)—funding (or institutional) liquidity, market liquidity, and central bank liquidity—they can be closely related, especially in times of stress. New York Fed President Bill Dudley called this a "negative feedback dynamic," whereby declines in funding liquidity due to market stress may make institutions less willing to provide market liquidity, which may further impair funding liquidity.
The interrelatedness of funding liquidity with market liquidity can make the goal of getting a grip on liquidity seem like nailing Jell-O to a wall. Pete Kyle from the University of Maryland addressed this head-on by noting these two forms of liquidity are essentially different sides of the same coin. Fixed income markets create funding liquidity by separating the collateral value of a security from its risk. Consequently, a firm's ability to access funding liquidity is directly related to the market's ability to trade the risk associated with that funding. Professor Kyle introduced a new model of market liquidity that includes both the price impact and time cost of executing a trade. Incorporating the speed at which different asset markets operate, according to Professor Kyle, allows us to both directly measure the varying degrees of liquidity that exist across markets, as well as assess the effects of events like fire sales and their impact on institutional liquidity.
Over-the-counter markets, such as those that deal in fixed income securities like corporate bonds and government debt, have historically relied on large banks to provide liquidity to buyers and sellers. In the wake of the financial crisis, new capital and liquidity regulations have arguably reduced the willingness of these institutions to maintain the scale of their earlier market making operations. In addition, the Volcker Rule explicitly eliminates their ability to engage in proprietary trading. This raises questions about how the market will evolve, about where and how nonbank financial institutions may step in to provide liquidity in the future and the role technology and innovation may play. Mani Mahjouri from Tradeworx provided a glimpse into the technology behind equity trading today that may suggest what is in store for bond markets in the future. Larry Harris of the University of Southern California noted it is not just about creating electronic markets for bonds, but allowing market participants to reach each other in a more cost-effective manner. According to Jamil Nazarali from Citadel, ultimately this is why centralized clearing is a critical component to expanding nonbank liquidity in the bond markets.
Conference discussions also explored the role of central banks' activities on debt market liquidity and whether they should expand their abilities to act as lenders and market makers of last resort. An important part of that discussion related to the use of securities as collateral for borrowing funds. Charles Kahn of the University of Illinois demonstrated that use of such securities, and its reuse as collateral through a process sometimes known as rehypothecation, is an important component of providing liquidity to the financial system. Marvin Goodfriend of Carnegie Mellon University noted, however, that expansionary monetary policy, such as the quantitative easing conducted by the Federal Reserve, pulls valuable collateral like US Treasuries out of the market. Pulling collateral limits the amount available for lending by institutions, and with it, the amount of liquidity available to the financial markets. Manmohan Sing of the IMF also noted that the amounts of unconventional monetary policy may have resulted in some "rusting of the pipes," which may make it challenging to return to pre-2007 levels of collateral reuse and market liquidity. This discussion of the financial market consequences complements the more typical debate of quantitative easing as a monetary policy tool (for instance, Ben Bernanke's 2012 Jackson Hole speech).
The interrelatedness of funding liquidity, market liquidity, and central bank liquidity means getting the institutional details right is critically important. Corporate bond funds, for example, have drawn recent attention from regulators and policy makers as a potential source of risk to the financial system because of their rapid growth since the financial crisis and the inherently illiquid nature of the assets they hold. If investors were to submit large redemptions en masse, the concern is that fund managers may liquidate their bond holdings through fire sales and transmit financial distress to other bond holders, as Itay Goldstein from the University of Pennsylvania cautioned in his talk. These systemic risks, several practitioners were quick to note, may be overstated. Sean Collins from ICI showed that investors in corporate bond funds are overwhelmingly households with long investment horizons. Gregory McGreevey from Invesco further noted that corporate bond funds have maintained a strong liquidity position and have been able to withstand significant redemption requests without resorting to selling large portions of their portfolios. Additionally, according to Barbara Novick from Blackrock, corporate bond funds are a small portion of this market and comprise less than 20 percent of all corporate bond assets. As she put it, looking at the partial data, although true, can be misleading.
There are a variety of opportunities to improve funding and market liquidity through innovation. Phil Prince from Pine River Capital Management suggested emerging technologies like the blockchain could make collateral more available to the markets and thus improve funding liquidity for institutions. Seth Merrin from Liquidnet further cautioned that regulatory innovation should be based on promoting market efficiency the capital formation process, and investor confidence as it responds to emerging risks and activities. The success of efforts like these, however, will hinge on the details of the structure of assets in the market. Jeffrey Tessler from Deutsche Bourse noted, for example, that there is no such thing as a "European" government bond – despite sharing a common currency unit, each nation issues its own debt according to its own laws and trading and settlement practices.