The one thing bond markets are really in need of, is more two-way liquidity in stressed markets. Yet that is nowhere on the regulatory agenda. It should be. The intermediary model for risk transfer in bond markets is breaking down.
There are a multitude of regulatory initiatives in Europe and the US designed to improve fixed income market function. These are largely based on increasing transparency and creating a well-regulated structure for the electronic trading of bonds. Everything from the creation of the consolidated tape of post-trade information in Europe, to the expansion of the existing tape – TRACE – in the US, to the trading venue perimeter discussions in both jurisdictions, are all progressive. They reduce the bias of price formation and risk transfer towards larger players. In the maxim ‘fair and efficient markets’ which most regulatory organisations aspire to, transparency and electronification support both aspects. However, there are limits to the difference they can make.
As one trader noted at the European Fixed Income Leaders’ Summit in October this year, “If I have all the price data, and the best execution management system, but there is no dealer on the other side to make a bid, none of it matters.”
In 2022, that point is coming into laser beam focus for many trading heads, as the absence of dealers has become more pronounced.
Why a liquidity crisis is looming
Ten years of relatively low rates and volatility twinned with record debt issuance created a pile of debt with relatively low yields, consumed in part by central banks.
Now that rates are rapidly rising, central banks are not hungry and issuance is falling, investors need to sell the low yielding debt and to buy the higher yielding debt, increasing the pressure to manage debt investment in secondary markets. Yet in any sell-off, banks stop buying. They argue that they cannot hold those bonds for any length of time, because it creates risk for which they have to assign capital, and that is too expensive. In certain circumstances sell-side trading desks have told their clients on the buy-side that their hands are tied with the decision coming from higher up in the team.
Improving the ability of market makers to support clients in secondary bond markets is a job for regulators because there is no other stakeholder in the capital markets sphere able to make a significant difference. Commercial pressure does not work. Even the biggest buy-side firms cannot get liquidity in stressed markets.
It is also a systemic issue. Leverage has increased across markets during the last ten years of low volatility and the sudden reintroduction of vol is playing havoc with leveraged pension investments and energy markets. Efficient markets require professional risk taking. There is no other mechanism to replace that.
‘Tis the season to be risk free
Liquidity will always be worse at year end. It is the season in which banks report on the health of their books to regulators, and that means they are risk off.
With rates higher, credit events are likely to increase. The end-of-year holiday will represent the point for many western retailers to assess their performance and inflation could lead to lower spend over this period. It is not impossible to see a sell-off next year in which leverage in the system triggers a liquidity crisis. The more risk market makers can take, the softer the sell-off and the smaller the crisis.
If there is a single New Year’s resolution that regulators make for 2023 it should be to address this issue.
©Markets Media Europe 2022
