Liquidity provider
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The BIS hosts nine international organisations engaged in standard setting and the pursuit of financial stability through the Basel Process. Drawing from a recent report by the Committee on the Global Financial System, we identify signs of increased fragility and market liquidity provider definition of liquidity conditions across different fixed income markets.
Market-making is concentrating in the most liquid securities and deteriorating in the less liquid ones. The shift reflects cyclical eg changes in risk appetite as well as structural eg tighter risk management or regulation forces affecting both the supply of and demand for market-making services. Although it is difficult to definitively assess the market implications, we outline several possible initiatives that could help buttress market liquidity.
Recent bouts of volatility remind us that liquidity can evaporate quickly in financial markets. The bond market sell-off in "taper tantrum" highlighted that liquidity strains can spread rapidly across market segments BIS In sovereign debt and, to an even greater degree, corporate bond markets, liquidity hinges in large part on whether specialised dealers "market-makers" respond to temporary imbalances in supply and demand by stepping in as buyers or sellers against trades sought by other market participants.
Analysing what drives the market liquidity provider definition of these liquidity providers is a precondition for understanding how well placed markets are to accommodate potential future shifts in supply and demand, particularly during times of elevated market uncertainty. In the wake of the recent global financial crisis, several developments suggest that market-makers are changing their business models.
These changes, their drivers and the potential impact that both might have on fixed income markets are of particular interest to policymakers, given the relevance of these markets to monetary policy and financial stability.
We see signs that market liquidity is increasingly market liquidity provider definition in the most liquid securities, while conditions are deteriorating in the less liquid ones "liquidity bifurcation". The trend can be seen in both the supply of and demand for market-making services, and reflects both post-crisis cyclical conditions such as diminished bank risk appetite and strong bond issuance and structural changes in the markets themselves such as tighter risk management or regulatory constraints.
Yet it is difficult at this stage to say definitively what these developments mean for fixed income markets over the long term. Nevertheless, we consider what kinds of policies and market market liquidity provider definition might help support market liquidity in the future. The remainder of this article is market liquidity provider definition as follows. The first section looks into the link market liquidity provider definition market-making and market liquidity, and identifies recent trends and their drivers.
The second section discusses implications for markets and policy, followed by a short conclusion. Markets are liquid when investors are able to buy or sell assets with little delay, at low cost and at a price close to the current market price see eg CGFS Market liquidity depends on a variety of factors, including market structure and the nature market liquidity provider definition the asset being traded.
Another key distinction see the next section is between normal times "fair weather" liquidity and more stressed environments, when the functioning of markets is challenged by large order imbalances Borio One feature of bond markets that limits their liquidity is that individual issuers may have a large number of different securities outstanding.
This makes bonds a relatively heterogeneous asset class in which many securities are thinly traded. Thus, trading in any individual issue is market liquidity provider definition infrequent and lumpy.
This reduces the probability of matching buyers and sellers of any given bond at market liquidity provider definition given time. For that reason, bond markets, particularly those for corporate issues, tend to rely on market-makers, typically banks or securities firms. The essence of market-making is to fill client orders in one of two ways.
In the first instance, a market-maker matches a buyer and a seller of an asset, a practice known as agency trading. If no match can readily be found, the market-maker will itself step in as buyer or seller. In other words, the institution executes its client's trade by using its own balance sheet, a practice known as principal trading.
In doing so, market-makers provide "immediacy services" to clients and other market participants. Their readiness to immediately execute a trade supports market liquidity and facilitates price discovery.
The market-maker's willingness to absorb temporary imbalances market liquidity provider definition supply and demand is thus vital to smooth market functioning. Market-makers follow a number of different business models, but broadly share some common features CGFS These include a sufficiently large client base to get a good view of the flow of orders; the capacity to take on large principal positions; continuous access to multiple markets, including funding and hedging markets; the ability to manage risk, especially the risk of holding assets in inventory; and market expertise in providing competitive market liquidity provider definition for a range of securities.
One is market liquidity provider definition facilitation revenues. These reflect bid and ask spreads - that is, the difference between the market-maker's prices for buying and selling an asset, net of the cost of trading. The second is termed inventory revenues. These reflect changes in the value of an asset held in inventory, plus accrued interest, and funding and hedging costs.
Regulatory requirements will affect profits via market liquidity provider definition impact on capital, funding and hedging costs, as well as the direct costs of compliance. It follows that market-makers will set their bid and ask prices based on their expectations of the cost and risk of holding assets in inventory. Spreads will tend to be narrow if market-makers believe they can execute trades quickly and cheaply, or if funding and hedging costs are low.
Thus, a market's liquidity depends on the depth and efficiency of related markets, such as those for funding and hedging. The difference between actual and desired inventory levels is important to market-makers, who all have risk management frameworks that set limits on holdings of different assets. When institutions approach those limits, they tend to adjust their quoted prices to realign their inventory. As a result, if an institution is trying to reduce risk, it may cut back on its market-making activity.
If many market-makers are reducing risk at the market liquidity provider definition time, markets lose liquidity. Moreover, when market volatility rises, standard risk assessment models will signal that a market-maker's inventory has become riskier.
That may prompt the market-maker to further trim its holdings. In turn, bid-ask spreads may widen, which could ultimately provoke additional volatility and diminish liquidity further.
Risk-taking is an integral part of market-making, particularly in less liquid markets like those for corporate bonds. Market-makers must be willing to take on risk by building inventory positions see Box 1 for a discussion of the economics of market-making. The riskier a position, the greater the return a market-maker will demand. Risk tolerance is also a factor, and will in turn be influenced by the market-maker's balance sheet strength market liquidity provider definition funding conditions.
Given the recent crisis experience, many of these factors are evolving. How have market-making and bond market liquidity changed post-crisis? Unfortunately, there is no single measure of market liquidity or of market-making activity to provide a clear-cut answer Fleming In addition, data with which to evaluate liquidity trends across markets and debt instruments are also hard to come by. Nevertheless, available data and softer sources of information, such as market intelligence, allow some inferences to be drawn.
Overall, these suggest that market liquidity is increasingly concentrating in the most liquid securities and market segments, while conditions are deteriorating in the less liquid ones. The left-hand panel charts the gap between market-maker buying and selling prices for sovereign bonds market liquidity provider definition in US dollars and euros, market liquidity provider definition. These bid-ask spreads have broadly returned to levels comparable to those that prevailed before the global financial crisis, indicating that liquidity has largely recovered in major sovereign bond markets.
Interviews with market participants confirm this trend. Another widely followed liquidity measure is the price impact coefficient. This metric looks at how much securities prices rise or fall when investors initiate a transaction Fleming Since then, the estimated price impact coefficient in the US Treasury market has more or less returned to pre-crisis levels, notwithstanding some brief spikes when markets turned volatile.
Data for other debt markets, such as corporate bonds, are typically more difficult to obtain. To be sure, corporate bonds are generally much less liquid than sovereign bonds. But, starting from these lower levels of market liquidity, corporate bonds seem to have witnessed a decline in liquidity in many jurisdictions - at least according to this particular metric.
Yet, if corporate bonds have indeed become less liquid, it is not because trading volumes are lower. While these observations suggest that liquidity conditions market liquidity provider definition have deteriorated relative to those inmost observers agree that bid-ask spreads at the time had been unduly narrow owing to market participants' search for yield in the run-up to the crisis BIS - an market liquidity provider definition bearing some similarities with current conditions BIS Supporting the mixed picture presented above, market intelligence confirms that differentiation in liquidity conditions across and within market segments is growing - pointing to increased market bifurcation.
In interviews, many market participants say trading large amounts of corporate bonds has become more difficult. They note, for example, that the size of large trades of US investment grade corporate bonds so-called "block trades" has continuously declined in recent years.
Increased bifurcation reflects changes in the behaviour of both market-makers' and their clients - that is, in the supply of and demand for market-making services. On the supply side, one apparent trend is that market-makers are focusing on activities that require less capital and less willingness to take risk. In line with this trend, in many jurisdictions banks say they are allocating less capital to market-making activities and are trimming their market liquidity provider definition, particularly by cutting holdings of less liquid assets.
However, trends differ across countries. In the United States, the net corporate debt securities holdings of securities market liquidity provider definition, including securitisations backed by assets such as credit card debt, have fallen sharply since Australia shows a similar trend.
Another trend is greater focus on core markets and clients. A number of market-makers have reportedly become more selective, mainly servicing core clients that generate income in other business lines.
Others are narrowing their scope to a smaller range of markets. In many jurisdictions, market-making has thus shifted from a principal trading model towards a client-driven brokerage model. As a result, many market-makers have become reluctant to absorb large positions and consequently need more time to execute large trades.
In Australia, for example, several foreign banks have ceased their market-making in corporate bond and derivatives markets in recent years and have drawn down their inventories. But, in less active markets, domestic banks may also be pulling back, resulting in an overall loss of market liquidity provider definition. In addition, proprietary trading ie position-taking for purposes other than market-making has reportedly diminished or assumed a more marginal importance for banks in most jurisdictions.
Expectations are for banks' proprietary trading to generally decline further or to be shifted to less regulated entities in response to regulatory reforms targeting these activities Duffie Overall, though, such a wind-down of proprietary trading will tend to limit market-makers' ability to redistribute risky market liquidity provider definition. Combined with reduced risk-taking in the financial system as a whole, this would then further reduce market-makers' willingness to build up large inventories of less liquid assets.
What are the drivers of these changes in the supply of market-making services? Evidence suggests that these trends stem from a broader post-crisis response that has both cyclical and structural elements. On the more cyclical side, as noted above, market participants confirm a reappraisal of risk tolerance among market-makers in the wake of the financial crisis and associated cutbacks in market-making activity - a finding supported by recent research Adrian et al Market-makers in many jurisdictions are thus raising the risk premia they demand in exchange for their services.
They are also reviewing their risk management operations and are increasingly assessing the value of trades on a case by case basis. On the structural side, regulators have taken steps to strengthen the financial system.
These include requiring key market-making institutions to strengthen their balance sheets and their funding models. Market liquidity provider definition structural improvements protect the financial system by making it less likely that banks will suffer liquidity crises or that such crises will market liquidity provider definition contagiously from one institution to another see below.
