A paper by the Financial Stability Board (FSB), which coordinates international regulatory efforts to promote effective policies, has reported that dealer blame uncertainty over the Covid pandemic for their reluctance to hold risk positions in March 2020, which liquidity was severely disrupted.
The research, entitled ‘Liquidity in Core Government Bond Markets’ found an absence of dealer engagement in market making across some parts of the market in March 2020 was a precursor to the bidless markets seen in parts of the fixed income space during 2022.
Teh analysis by the FSB found the most commonly reported ‘highly relevant’ factor for dealers’ reluctance to hold assets in their inventories was a lack of clarity on the evolution of the pandemic and hence information on how long the positions needed to be held on their balance sheet.
It also found that:
- The large one-sided flows associated with the most severe part of the turmoil both in the cash and repo markets made it difficult for dealers to expand their liquidity provision further. For instance, econometric analysis in the UK suggests that, for the term repo market, the increase in spreads was more due to demand for liquidity rather than supply of liquidity factors.
- Value-at-risk (VaR) limits were increased by many dealers during the turmoil to reflect the heightened levels of uncertainty. However, aggregate risk limits (e.g. notional balance sheet or position size limits) may not have changed significantly for some desks and might have limited the expansion in dealers’ market-making activity in government bond markets.
The factors reported as ‘somewhat relevant’ included:
- Operational issues and working from home (WFH) arrangements in cases of inexperienced traders, as a result of the “juniorisation” of trading desks in recent years, were cautious taking on and managing large risk books making the WFH environment initially more challenging.
- Difficulty in hedging impacting dealers’ incentives to intermediate in cash and futures markets as well as proprietary trading firms (PTFs) activity in the futures market and in the US cash market. Hedging positions in long-dated government bonds is difficult in many jurisdictions and may partially explain why liquidity was more impacted for longer maturities.
Prudential regulations were not seen as a primary driver of dealer behaviour, but the leverage ratio has had an impact at the margin for some jurisdictions.
Some participants noted that changes to the structure of cash and repo markets could help in increasing resilience, in particular central clearing for repo.
The paper concluded that severe dislocations experienced in the government bond market during the March 2020 turmoil were the outcome of “large spikes in the demand for liquidity by a variety of market participants, especially non-banks,” with a “dash for cash” as investors tried to sell highly liquid assets to fulfil their cash needs.
“Many investors used their liquidity buffers, by monetising safe assets in private markets. In addition, the dash for cash reflected the need to raise cash to meet investor redemptions to raise USD funding and to unwind leveraged positions,” the authors wrote.
The FSB has said that policies to consider include measures to:
- Mitigate unexpected and significant spikes in liquidity demand, which may involve selling (or repo) near-cash instruments such as government bonds;
- Enhance the resilience of liquidity supply in stress; and
- Enhance markets’ oversight, risk monitoring and the preparedness of authorities and market participants.
“Reducing potential demand for liquidity in stress is crucial for enhancing the resilience of government bond markets. Work is already underway by the FSB and standard-setting bodies to assess and mitigate unexpected and significant spikes in liquidity demand. Insights from this report can provide input to the work of these groups, e.g. on the extent to which different market participants rely on government bond and repo markets to manage their liquidity and its potential effects in stress.”
It has also recommended looking at ways to increase the availability and use of central clearing for government bond cash and repo transactions and the use of all-to-all trading platforms.
“To enhance risk monitoring and preparedness, policies to consider include increasing the level of transparency in government bond markets, so that timely and accurate information is available to market participants and authorities. This includes closing some of the substantial data gaps identified in the report such as, for example, the regulatory reporting of all transaction data to authorities, including the identity of participants in the bilateral repo market and the activities of PTFs.”
However, it noted that these policies are “unlikely to be sufficient by themselves to prevent liquidity imbalances in all future stress events, but they could help mitigate the frequency and magnitude of those imbalances. Authorities may want to consider how these policy options could potentially be combined to increase the resilience of their government bond markets, including possible trade-offs, impacts and complementarities.”
