By Joseph Neu
Growing concerns about constraints on fixed-income market liquidity should prompt contingency planning by treasurers.
There is a rising chorus of concern regarding the reduction in the provision of liquidity to fixed-income markets and the conundrum this is creating for policy makers, investors and the wholesale banks and asset managers that serve the market. The conundrum deepens when market participants consider what will happen when interest rates finally rise and selling pressure builds to exit fixed-income positions. Non-bank corporates both as investors and as issuers are not immune to the conundrum either. Treasurers, risk managers, and others should have contingency plans in place.
Understanding the conundrum
Morgan Stanley, sponsor of The NeuGroup’s Bank Treasurers’ Peer Group (BTPG) meeting in May, alluded to this in its joint report with Oliver Wyman, “The Liquidity Conundrum: Shifting risks, what it means.” And during the meeting, in a discussion on deposit sensitivity to interest rates, Morgan Stanley indicated that this is the tip of the iceberg on fund flows. Its report defines the liquidity problem as follows:
“At its heart is the huge shift in liquidity risks to the buy-side and asset owners as the twin forces of financial regulation and QE have played out. New rules have driven a severe reduction in sell-side balance sheet and banks’ liquidity provision. Wholesale banking balance sheets supporting traded markets have decreased by 40% in risk weighted assets terms and 20% in total balance sheet since 2010.”
Unfortunately, the report also notes that the problem will only get worse, as it comes at a time when the liquidity of secondary fixed-income markets is likely to deteriorate. This is happening as “regulatory costs continue to drag on returns” and amid expectations of shrinking fixed-income balance sheets from the largest wholesale banks in the next two years. Trading in all financial markets will be affected, but the impact on credit markets may be the thorniest, Morgan Stanley says. In addition “there is an unresolved conflict in regulator desires” to reduce the interconnectedness between banks but still deliver on investor promises. Related to this is the impact of the current rate environment, which is luring even more money into less liquid bonds.
This conclusion is reinforced by the IMF’s Global Financial Stability Report from last October, which noted how “accommodative monetary policies have induced greater risk taking by market participants, as reflected in rising asset flows into mutual funds and riskier exchange-traded funds (ETFs).
According to the IMF, one big stress would be a “bumpy exit” scenario by the Fed, one that could result in a faster-than-expected rise in term premiums (e.g., 100bps increase in 10-year term premiums), as similar widening of credit spreads (e.g, a 100bps increase in 10-year term premiums), and a rise in financial volatility that spills over to global markets. Even a more basic normalization of monetary policy could trigger instability in the fund sector if it results in sustained losses for investors, the IMF report notes.
This might help explain why the US Fed wants to appear so sanguine about market liquidity in the Treasury market: “All told, while the current level of liquidity in the on-the-run interdealer market seems healthy, some aspects of price movements and liquidity metrics in this market warrant careful monitoring,” it noted in a July 15 Monetary Policy Report.
Discussing the impact
Banks, as demonstrated by discussion at the BTPG meeting, are keenly concerned about the flow-of-funds dynamics that will be triggered by rising rates. This covers the whole spectrum, from deposits on to money market funds, repo and other rate-driven securities, as well as bonds. These concerns tie to liquidity too, given the regulatory definition of HQLA for their LCR calculations, a key liquidity metric.
Cash-rich corporates, meanwhile, including members of The NeuGroup’s Tech20 Treasurers’ Peer Group, also have reason to be concerned about their cash portfolios. They were provided insight by Bank of America Merrill Lynch, sponsor of the Tech20’s May meeting, on how negative interest rates in Europe are upping the competition for positive-yielding investment opportunities, which mostly trade liquidity for positive return. Being forced to pay up for liquid assets pushes even risk-averse corporate cash to flow toward risk assets.
As issuers of corporate bonds of increasing size, Tech20 members were also shown by BlackRock (at the Tech20’s November meeting) a means by which they could help market liquidity. That is, they need to consider “superliquid” issues to facilitate e-platform trading and other aids to the secondary market. In other words, the largest investment-grade issuers would have to consider issuing fewer, more standardized bond offerings that would create more focused supply and trading windows to boost secondary market activity and liquidity.
BlackRock has built on that advice in a whitepaper issued this July, “Addressing Market Liquidity,” that suggests further solutions to address liquidity issues in fixed-income while also ensuring market participants have greater clarity. Unlike the Morgan Stanley/Oliver Wyman report, BlackRock sees the liquidity conundrum as more of a natural evolution than a regulatory issue. The NeuGroup’s Treasury Investment Managers’ Peer Group (TIMPG) meeting in the fall will deal with this topic in a session, specifically, how to deal with the changing environment whereby banks and other broker-dealers are no longer relied on as intermediaries and asset managers; major investors thus must work to move fixed-income trading toward a hybrid agency market more akin to equity markets—one where asset owners bear the execution risk and trade. Trading protocols would also move from Request for Quote toward a Central Limit Order Book.
Stress-testing needed
While heightened risk awareness and adapting to new approaches in trade execution will help all participants in fixed income markets cope with the rising liquidity conundrum, more action is needed to prevent a crisis. Both the Morgan Stanley/Oliver Wyman and the more recent BlackRock reports offer some additional recommendations to help spur debate and action. Unfortunately, just like in California, where they face liquidity issues of a different sort, the ability for markets to respond to conundrums is never good until there is a crisis of dire proportions. Stress-testing for such extreme, adverse scenarios, as well as less dire ones is therefore a good idea.
The Morgan Stanley/Oliver Wyman report recommends stress-testing to ensure adequate liquidity for redemptions based on the last 35 years of redemption history. But the report also suggests that redemptions may even exceed those indicated by historical data given the presence of QE and the equally unprecedented efforts by central banks to exit from it—all while mutual funds that offer investors daily liquidity have increased their share of US credit 3x since 1994.
The October 2014 IMF Global Financial Stability Report labels this the liquidity mismatch problem, whereby redemption-prone vehicles like mutual funds and ETFs invest in less liquid assets. Meanwhile, the number of days required for full liquidation of US credit continues to climb (see chart above)—well past the seven-day redemption payment limit set for open-end mutual funds. Every treasurer it seems should have a good feel for how many days it will take to redeem cash investments holdings of various types (Treasuries, bonds, bank loans) for actual cash.
BlackRock recommends that market participants and regulators “work together to develop best practices for redemption and liquidity risk management.” It recommends the EU’s Alternative Investment Fund Managers Directive (AIFMD) as providing a good model for rules around liquidity risk management, in particular rules around stress-testing of portfolio holdings under various redemption scenarios. To improve stress-testing, asset managers and investors need better models and better data to input into them.
Accordingly, BlackRock recommends that policy-makers “create guidance requiring that transfer agents, distributors or some other entity (e.g., a central data repository) aggregate information on investor types redeeming and subscribing from funds to help forecast future redemptions.” It applauds the EU’s efforts with Markets in Financial Instruments Regulation (MiFIR) and the revised Markets in Financial Instruments Directive (MiFID) that are fostering greater transparency and better data.
There are several NeuGroup members that utilize their asset management firms’ risk management expertise, including BlackRock’s, to help do similar portfolio stress-testing. This is a good act to follow and more treasurers should be developing capabilities to do this both with the help of external partners and in-house. Hopefully, you will also take the next step to look at contingency funding options to fill gaps in liquidity under various stress scenarios. Stay thirsty.