Illiquidity in Fixed Income

Markets
Examining the recent debate on liquidity in fixed-
income markets and asking 'Is liquidity always a
good thing?'
 Liquidity

Liquidity is crucial to the functioning of any market. Liquidity essentially measures the ease
with which an investor can exchange an asset, at the shortest notice and without loss, to the
most liquid asset, which is cash. Liquidity can be measured by the difference between the
ask price, the minimum price demanded by a seller of a security, and the bid price, the
maximum price proposed by a buyer. The lower the bid-ask spread, the more liquid the
security.
Liquid assets include cash held in domestic currency (foreign currency, although liquid,
requires an exchange rate to be determined), cash equivalents traded on major exchanges
such as Treasury bills and debt receivables. However, these are just general guidelines.
Asset liquidity is 'ephemeral by nature' and is a function of when the asset is bought/sold
and the quantity involved. When the holder's 'desire to sell an asset increases [...], his ability
to sell it decreases’ (Marks, 2015).
A market is said to be liquid if there are 'always bid and [ask] prices' for small volumes of
trading; if 'the spread is always small'; if larger volumes can be sold over a long period of
time 'at a price not very different[...]from the current market price'; and if large volumes can
be sold immediately, but at 'a discount that depends on the size of the block' (Black, 1971).
Liquid markets have extremely tight spreads and prices within these markets 'eventually
tend to their underlying value', indicating resilience to large trades. A market is considered
highly liquid if it has great 'depth', meaning it requires a large amount of transactions to
alter the price (Kyle, 1985).
Without liquidity in a market, buyers and sellers are frustrated in their attempts to trade
assets without incurring unacceptable losses in value and time. The market as a whole
becomes less efficient, with an increasing disconnect forming between asset prices and
underlying developments in the economy. This causes potential investors to hold off on
investment decisions and contributes to economic stagnation and recession. In a 'flight to
quality', where investors, seeking a safe haven for their money during a crisis, flock to ultra-
safe Treasury bills, market liquidity in all other bond and asset classes suffers as investors
lose confidence with the market. At the beginning of the financial crisis in late 2007/early
2008, the demand for short term Treasury bills as a 'port in a storm' for investor's money
was so high that the yield on these bonds turned negative. (IMF;2008,2015)

Examining the Debate on Market Illiquidity

In recent months, concern has grown about the liquidity situation in global fixed-income
markets, the largest of which are the bond markets.
The main issue of the Bank of England's Financial Stability Report is the fragility in secondary
market liquidity. Liquidity in the secondary market depends on market makers such as banks
or securities firms. Bond trading is more 'infrequent and lumpy' than equity markets. In the
U.S. for example, the average trades per day of the most liquid investment grade bonds
stood at 85, compared to 3,800 for equities. The average trade size of these bonds was
$500,000, compared to $7,000 for stocks (ZeroHedge, 2015).
The electronic exchanges which grease the wheels of equity market liquidity are nowhere
near as prominent in fixed-income markets. The bond market is stuck with '19th century
practices', with deals concluded over the telephone between brokers and their clients (WSJ,
2015). This 'infrequent and lumpy' trading relies on intermediaries ability to 'act as a
warehouse' and provide immediacy to buyers and sellers.
One of the main trends identified in recent BoE and Bank for International Settlements (BIS)
reports is market maker's diminished appetite for building inventories of sovereign and, in
particular, riskier corporate bonds. Prior to the financial crisis, the fixed income units of
banks and financial institutions devoted large resources to matching buyers and sellers for a
fee, or to acquiring a position themselves, in the process building up large inventories of
debt. The financial crisis forced a sharp reduction in these operations, through the Volcker
rule section of the Dodd-Frank reforms and changes to Basel 3 regulations, which limit banks
activities to meeting customer demands. (BIS; BoE, 2015)
A heavier regulated and more risk averse banking sector has reduced market making supply
at the worst possible time, as corporations and emerging markets continue to flood the
markets with debt instruments. While a market with 'few, homogenous securities' combined
with 'many, heterogeneous market participants' would create a near perfect liquidity
situation (Marks, 2015), in fact the complete opposite situation has developed.
To the increasing concern of policy makers worldwide, the discrepancy between debt
issuance rates and trading volumes is manifesting itself in markets previously assumed
immune from liquidity problems. U.S. Treasury bills, the benchmark for liquid assets, 'have
seen a sharp decline in trading volumes relative to the size of the burgeoning bond market'
(FT, 2015). In the last three years, observers have cited the 'taper tantrum' of 2013, the
'flash-crash' of October 2014 and the sudden spike in German Bunds in mid 2015 as
evidence that, even in the most liquid markets, unexpected shocks can cause the a facade of
liquidity to disappear in a very short space of time (Roubini, 2015).
The situation may be even worse in the corporate bond market. Even accounting for the fact
that corporate bonds are generally less liquid than sovereign bonds, the booming rate of
new debt issuances has far outstripped the accompanying rate of trading volumes, with the
vast majority of trading concentrated among a small number of issues. This 'bifurcation of
liquidity' is a major issue for the corporate sector and its use of bond markets as a source of
funds. In recent years, there has been a trend of 'block trade sizes of U.S. Investment Grade
corporate bonds declining continuously' (BIS, 2015).
While tighter regulation and higher capital charges are inducing banks and other financial
institutions away from active trading in fixed-income markets, the open-ended funds of
retail investors, 'scarred by the financial crisis', have sought safety in the bond markets. (FT,
2015) However, the nature of these funds is such that investors can exit overnight, meaning
there is a danger that when shocks occur, the price will quickly spiral as investors race to the
bottom to liquidate their holdings.
Illusory liquidity is not just an issue for investors and the corporate sector, but also for
governments. In the U.K, an aggressive Quantitative Easing programme implemented by the
Bank of England during the financial crisis has left it with 24% of total outstanding U.K.
government bonds (gilts). With regulatory requirements obliging commercial banks and
financial institutions to hold gilts to satisfy capital requirements, another 9% of the gilt
market is spoken for. Of the remaining two thirds, 29% is held by pension and insurance
funds, many of which are highly constrained in their gilt trading practices (Telegraph, 2015).
With such a high proportion of the market in effect cut off from active trading, there is
inevitable concerns about the ability of the gilt market to withstand liquidity shocks. With
bond trading increasingly shifting away from large block trades to smaller volumes (BIS,
2015), the effect on liquidity in the market when the Bank of England decides to begin
selling its gilts, comprising nearly a quarter of the total market, is unclear.
The combination of simultaneous 'high money liquidity' created by central banks using Q.E.
and rock bottom interest rates and low trading liquidity caused by such a large concentration
of bonds held inactively by central banks creates 'air pockets' which are prone to sudden
price swings and higher volatility (Deutsche Bank, 2015).
The rise of electronic trading has been attributed as a cause of this illusory 'phantom
liquidity'. The nature of e-trading is such that any significant amounts of price volatility
automatically stops, or significantly reduces, an operator's trading. The 'flash-crash' of
October 2014, when U.S. Treasury bill yields fell by 37 basis points in a single day, has been
linked to sudden shut-downs in banks and other financial institutions e-trading platforms
(BoE; IMF, 2015).
Electronic trading is a controversial topic in current financial discourse. The supporters of e-
trading claim that it allows for a more heterogeneous investor base by speeding up the
execution of trades and breaking up large volumes into easily-traded smaller bundles. They
argue that the 'increasing competition' provided by a 'more diversified set of actors' has led
to improved market liquidity. The New York Federal Reserve President does admit however,
that rapid e-trading, known as high-frequency trading, is a probable cause of market
incidents such as the aforementioned 'flash-crash', as HFT's complex interactions 'play out
faster than the timeframe in which human intervention can occur' (Dudley, 2015).
However, electronic trading and HFT are not viewed as the saviours of liquidity by other
market observers. The 'lumpy' nature of bond market trading, outlined at the beginning of
this section, means that, although e-trading can provide an expedited trade for smaller
volumes, large trades still require dealer intermediation. While it may seem that, on normal
trading days, liquidity is present, in reality when major shocks occur, automated trading is
not suited to withstand these 'periods of stress' and simply creates a 'liquidity illusion',
which is neither deep nor resilient (ZeroHedge; Brainard, 2015).
The extent to which liquidity has declined in fixed income markets, if at all, is disputed
however. In the period from the end of the dotcom crash and the beginning of the financial
crisis, markets were 'abnormally liquid', meaning that drawing comparisons between the
new liquidity situation and the boom of the last decade may be oversimplifying the new
reality (FT, 2015). Using a traditional measure of liquidity, the quoted bid-ask spread in U.S.
Treasuries, the data does not point to any significant deterioration in liquidity in the years
following the depths of the financial crisis. The distortion caused by Q.E. means that any
conclusions drawn from examining Treasury yields are subject to debate. In the corporate
bond market, believed to be at the forefront of liquidity concerns, price impact, a measure
of the effect on price from a $1m trade, has been 'trending down since the early 2000's',
apart from the understandable spike during the financial crisis (Dudley, 2015). With the
boom in bond issuance, and the technical innovation of electronic trading, it is now possible
to trade a record number of securities over more platforms reaching more traders than ever
before.

Policy Responses

In order to avoid 'liquidity black holes' from developing, regulators and central banks must
encourage a diversity of the investor base in the fixed-income market. The advent of
electronic trading and continued innovation in the marketplace will have a major role to play
in bringing bond markets in line with more sophisticated equity markets.
In markets with severe liquidity issues, more proactive approaches are needed. These
markets are often contain securities for which months have passed since their last trade. In
order to ascertain a fair price for the security, which is difficult when such a long time has
passed between trades, and stimulate trading, innovations such as the U.S. Treasury's Public
Private Investment Partnership program should be studied and used as a basis for other
schemes. The program, which was essentially a 'price discovery' mechanism, incentivised
the capital markets back into trading (Marks, 2015).

Is Liquidity Always a Good Thing?

It would be remiss to finish this essay without examining the question 'Is liquidity always a
good thing?' While liquidity is paramount for markets and the economy to function, there is
growing evidence that too much liquidity may hamper trading and economic activity.
In the U.S., the Federal Reserve's Quantitative Easing program created a highly liquid
Treasuries market at the exact time when it should have been encouraging investment in the
corporate sector to stave off recession. By essentially creating a 'risk-free' investment, the
Fed reinforced the natural 'flight to quality' which occurs during every shock, reducing
liquidity in other markets, which may have exacerbated the crisis.
Excessive liquidity can encourage short term thinking and reckless investing. Liquidity 'lowers
the bar for investments' and causes investors to 'take a position casually, under the
assumption it would be cheap and easy to get out'. It can also 'convince investors to try their
hand as traders', which results in short term-ism and panic when the liquidity evaporates.
This argument was used as a basis for the ban on short-selling during the financial crisis, a
practice which was claimed to be deepening panic, and has also been used to promote the
imposition of a 'Tobin Tax' on financial transactions, to encourage longer term trading
positions (Krugman, 2009).

Conclusion

Liquidity provides the lubricant to a smoothly operating economy and is important in the
capital markets for companies and sovereigns to finance their debt. The increasing concern
with illiquidity in the bond markets cannot be ignored, despite the paucity of statistical data
to back up these claims. However, in formulating policy responses, decision makers must not
make the mistake of putting liquidity on a pedestal above all other considerations. The
reasoning for the increased regulation of financial institutions, which is cited as a factor in
declining liquidity, was to prevent another repeat of the near catastrophic economic collapse
of late 2008. In acting to address the liquidity situation in fixed-income markets,
governments and central banks must also recognise that liquidity is not always and
everywhere a good thing.

"If you aren't willing to own a stock for ten years, don't even think about owning it for ten
minutes" - Warren Buffett
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