A recent speech by Fed governor Jerome Powell highlights recurrent episodes of short-term distress and vanishing liquidity in large developed markets. Increases in trading speed, market concentration, and regulatory costs of market making all may be contributing to these liquidity events.

Powell, Jerome (2015), “Structure and liquidity of treasury markets”, Speech at the The Brookings Institution, Washington DC, 3 August 2015. http://www.bis.org/review/r150806b.htm?ql=1

The below are excerpts from the speech. Headings, cursive text and references to other posts have been added.

Recurrent short-term liquidity events

“It is…possible that liquidity may be more prone to disappearing at times of stress. On October 15 2014, for example, market depth declined sharply, and we saw a sudden spike in prices that was without precedent for a period with little relevant news. Other events – such as the 2013 ‘taper tantrum’, the’bund tantrum’ last spring, and the sharp moves on March 18 in the euro-dollar exchange rate – all broadly show the same pattern: rapidly diminishing liquidity, and large price moves for a given quantum of news.”

“On March 18, 2015, shortly after 4 p.m. EDT and two hours after the release of the March FOMC monetary policy statement, the euro rose over 3 percent against the dollar in a four-minute period and then reversed most of its gain over the next three minutes.”

LIQ01

Modern liquidity risk factors

N.B.: Liquidity risk is the probability that trading costs surge when trading is required, such as in a crisis for purposes of risk management.  This risk typically reduces expected returns. On the nature and measurement of liquidity risk view post here.

“Treasury markets have undergone important changes over the years…

  • Perhaps the most fundamental change in these markets is the move to electronic trading,which began in earnest about 15 years ago…Today these markets are almost fully electronic. Interdealer trading in the cash Treasury market is conducted over electronic trading platforms. Thanks to advances in telecommunications and computing, the speed of trading has increased at least a millionfold. Advances in computing and faster access to trading platforms have also allowed new types of firms and trading strategies to enter the market. Algorithmic and high-frequency trading firms deploy a wide and diverse range of strategies. In particular, the technologies and strategies that people associate with high frequency trading are also regularly employed by broker-dealers, hedge funds, and even individual investors. Compared with the speed of trading 20 years ago, anyone can trade at high frequencies today. The trading platforms in both the interdealer cash and futures markets are based on a central limit order book, in which quotes are executed based on price and the order they are posted. A central limit order book provides for continuous trading, but it also provides incentives to be the fastest. A trader that is faster than the others in the market will be able to post and remove orders in reaction to changes in the order book before others can do so, earning profits by hitting out-of-date quotes and avoiding losses by making sure that the trader’s own quotes are up to date…milliseconds. The cost of these technologies, among other factors, may also be driving greater concentration in markets, which could threaten their resilience
    (On the risk of ‘freak events’ in high-speed trading view post here.)
  • As traditional dealers have lost market share, one way they have sought to remain competitive is by attempting to internalize their customer trades – essentially trying to create their own markets by finding matches between their customers who are seeking to buy and sell. Internalization allows these firms to capture more of the bid-ask spread, but it may also reduce liquidity in the public market. At the same time it does not eliminate the need for a public market, where price discovery mainly occurs, as dealers must place the orders that they cannot internalize into that market…The type of internalization now done by dealers is only really profitable if done on a large scale, and that too has led to greater market concentration
  • Some observers point to post-crisis regulation as a key factor driving any decline or change in the nature of liquidity…I would agree that it may be one factor driving recent changes in market making. Requiring that banks hold much higher capital and liquidity and rely less on wholesale short-term debt has raised funding costs. Regulation has also raised the cost of funding inventories through repurchase agreement. Thus, regulation may have made market making less attractive to banks. There is a link between funding liquidity and market liquidity, and for Treasury markets the links to funding in the repo market are especially close. Post crisis reforms have made the repo market safer but also raised the costs of repo transactions.”

N.B.: A study on bond markets suggests that market makers’ risk tolerance and warehousing have declined after the great financial crisis and that tighter risk management has augmented pro-cyclicality of liquidity. On the disparity between more fragile liquidity supply and heavy liquidity demand view post here. On the negative liquidity effect of market maker’s balance sheet management during the 2013 taper tantrum view post here.

Why it is a concern for the Fed

“Treasury markets are important for the conduct of monetary policy. Treasuries serve as high-quality liquid assets (HQLA) for a wide range of financial institutions, including dealers in the Treasury market, and as collateral in myriad transactions conducted bilaterally and through clearing houses and exchanges. Treasury securities are a global reserve asset, and Treasury markets are a key vehicle through which market participants manage their interest-rate risk. The integrity and continued liquidity of the Treasury markets affect nearly everyone.”