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Fractured Liquidity – New Challenges in the Post-Lehman World

Fractured Liquidity – New Challenges in the Post-Lehman World
Salman Ahmed, PhD - Chief Investment Strategist

Salman Ahmed, PhD

Chief Investment Strategist

It has been 10 years since Lehman Brothers declared bankruptcy. What has changed?

We live in a very different post crisis world. I was a member of Goldman’s Economics team at the time and I remember the mayhem caused by that event as market practices which had taken hold in a highly de-regulated system were exposed and then played a strong role in seriously amplifying the initial shock. In this new post-crisis world, there is no doubt that the ability of free markets, when it comes to efficient resource allocation, has been challenged. 

In addition, ten years later there is still deep division amongst economists when it comes to public policy reaction to those system-destroying events we witnessed in the immediate aftermath of Lehman collapse. Recent commentary by economist Joseph Stiglitz who called “secular stagnation” an excuse by policy makers to pursue inadequate policies, and a subsequent rebuttal by Larry Summers shows that the thinking in this post-crisis era, despite the length and durability of the recovery especially in the US, remains deeply polarized. 

When I look ahead to the next business cycle, there are three major developments which have taken hold over the last decade and indeed have become key state variables in the current environment: 1. Economic shocks witnessed a decade ago have given way to rising populism across the developed world which is in turn leading to economic policy shifts. 2. Leverage in the global system is still very high and, in many cases, has increased further. We have seen no resolution on this front despite the deep global recession the global economy experienced post the Lehman event. 3. New regulations and increased capital buffers implemented post-2008 have made banks safer but have also generated unintended consequences. 

Point 3 is the most unappreciated yet equally, if not more, problematic for financial markets going forward.


What is Fractured Liquidity?

There is no doubt that central banks have become key players in asset markets (especially fixed income) and their involvement has raised a number of new challenges for investors, given policy objective function is very far away from profit maximization, which we the investors focus on. In addition, the heavy load of regulations has led to the problem of what we call “fractured liquidity” whereby, the new regulatory backdrop has seriously damaged the ability of broker/dealers to intermediate in secondary fixed income markets.


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In terms of evidence, a survey of the 13 largest European bond market makers recently confirmed they believe regulations, especially capital requirements, are impacting their ability to execute their responsibilities. Banks have to contend with higher capital requirements and more conservative risk definitions for use in calculating the capital required to support assets. This all makes it more expensive to hold corporate bonds.

Specifically, banks are now acting as brokers rather than true market makers. When market makers are restricted in their ability to intermediate in secondary markets, this causes a liquidity shortage and a fragmentation of the fixed income market. 

As a result, there are clear signs of fragmentation, both in the US and, to a lesser extent in Europe as well. For instance, the Barclays Liquidity Cost Score shows that the spread between the top and bottom decile of U.S. corporate bonds is increasing.


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This fragmentation within bonds is happening in investment grade (IG) and high yield markets, whereby some bonds are seen as more liquid and the other bonds are seen as increasingly illiquid and that dispersion is growing. In addition, studies such as Choi and Huh show that bid-offer spreads in the US corporate bond markets tend to be 20% to 40% higher when customers are demanding liquidity on dealer balance sheets. 


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In the background, corporate bond inventories have come down in Europe as well, probably less so than the US, but these dynamics have been playing out there as well. When looking at the implications on market behavior, a European commission study shows that average holding period by investors of both HY and IG bonds has almost doubled over the last 6 years, showing the deep impact these challenges are having on investor behavior. 


Where can we see evidence of fractured liquidity?

The current state of the Italian government bond market is a good example where we can observe fractured liquidity and how this can become very dangerous. Italian government bonds are a systematically important macro instrument, not least because, if European spreads blow up and stay higher, there are implications for European Central Bank (ECB) policy and the wider European Union. 

Following the formation of the populist coalition in May, we observed massive spikes in the two-year Italian Government securities (BTPs) spread, which was comparable to what we saw in the wake of the Eurozone crisis. The bid-offer spread blew up very significantly, so the cash bond market in BTPs effectively shut down. I am concerned about this BTP bid-ask spread blowing up and not recovering because of these underlying liquidity issues can then exacerbate a macro shock quite significantly.


How exposed are investors to this fractured liquidity?

Data from the IMF data shows that ‘herding’, or the commonality in positions held by investors, has gone up significantly. We have also seen the tracking errors of the largest asset managers in certain asset classes also come down, which means that they are gravitating towards very similar portfolios. 

This is down to the widespread use of benchmarks and portfolio allocations based on market-capitalization weightings (especially in fixed income). In fixed income, market capitalization-weighted portfolios give a higher weighting to the most indebted issuers, regardless of their capacity to repay their debt. In addition, quantitative easing has had a significant impact on who the most indebted issuers are. This convention is now leading investors into already crowded positions, which exacerbates their exposure to fractured liquidity in bond markets. 

What that means is if there is a shock to the market when everybody is on the same side then that creates potential problems. On a day-to-day basis a big asset manager can trade with another big asset manager, which is seen as a potential solution to mitigate the impact of weak dealer activity, but when there is herding, that causes a problem in a stress situation.


To what extent could fractured liquidity be a contributing factor in the next systemic crisis?

I started my career 18 years ago, so I have lived through two major recessions. In my view, before the downturn happens, everybody has an idea of what the causes are going to be, just not when it will occur. As mentioned above, I was at Goldman Sachs at that time of the financial crisis of 2007/8, and everyone was talking in years prior about how overvalued the housing market looked. Everybody was talking about the tech bubble in the run up to the dot-com crash of 2000.

These big shocks do not creep onto us; they are usually out there in the open. What is unknown is the timing of the shock or its trigger. This time around, it is the very easy monetary policy and the unintended consequences of heavy regulations. From an investor perspective, sustained easy monetary policy has distorted economic signals. It has distorted the link between fundamentals and economic signals. This adds to our work because we have to be careful whether that link is re-established or not and the consequences.  

In addition, I am worried about the role fractured liquidity can play in amplifying a shock, especially in the case of, for example, Italy, whereby even a moderate shock was amplified by the lack of liquidity in May. When market prices become a political issue, this could have ramifications for the design of the European Union as a whole.

In coming weeks, I intend to publish additional analysis on the above topic with focus on the mechanics behind this issue of fractured liquidity by drawing on the work of academics such as Darrell Duffie, who has done an excellent job in analytically parsing this challenge in order to better understand its drivers (for example see Funding Value Adjustments)


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