The Reserve Bank of New Zealand today published a Bulletin article that looks at liquidity in financial markets.
In recent years, financial market participants have become increasingly worried that the level and resilience of financial market liquidity has declined significantly, raising concerns over the efficiency of markets and increased the risks associated with a liquidity shock.
This article reviews international research on the topic, and generally finds evidence for a decline in the level and resilience of liquidity, although it has been mixed across markets. We also assess liquidity conditions in the New Zealand government bond, funding and short-term money markets using common analytical measures of liquidity as well as drawing on discussions with numerous market participants. We find that liquidity has declined to varying degrees across the different markets, and while risks of a liquidity shock have risen, the decline has been manageable thus far.
Liquidity is a complex concept, with the term encompassing a range of ideas. There are three main types of liquidity in financial markets: market liquidity, which reflects the ability of market participants to execute large transactions at low cost with only a limited effect on the price; funding liquidity, which refers to the ability of an organisation (such as a bank) to raise debt as required at a reasonable cost; and monetary liquidity, which reflects the looseness of monetary conditions, in part owing to the stance of central banks. This article focuses primarily on developments in market liquidity, although funding and monetary liquidity are also discussed where relevant.
Market liquidity is important for the functioning of financial markets, helping to facilitate the efficient distribution of resources through the allocation of capital and risk. A lower level of market liquidity can reduce these efficiencies, potentially inhibiting economic activity. While the level of liquidity in a market is important, the resilience of liquidity in a market is also key, especially in the face of a shock. The IMF note that highly resilient market liquidity is critical to financial stability, because it means market prices are less prone to sudden sharp swings, and more likely to remain aligned with values determined by fundamental factors.
Growing concerns about liquidity from market participants have been stimulated by a number of “shock” events over the past few years. Events such as the October 2014 Treasury market “flash rally” and the April 2015 “Bund tantrum” saw rapid moves in bond prices over short periods of time that did not appear to be explained by fundamentals. These moves are seen by many as evidence of reduced liquidity in some key markets.
While bond market liquidity has been a key focus for several studies, liquidity concerns are not confined to this asset class. Foreign exchange markets have also been affected – including for the New Zealand dollar. For example, the NZD/USD cross rate on 25 August 2015 (NZ time) fell as much as three cents over 10 minutes, before quickly rebounding.
We found that international research into recent liquidity developments generally identified a decline in market liquidity, although this was not evident in all markets. There is also evidence that the resilience of liquidity has declined in some markets, increasing financial stability risks. The primary drivers for the decline in liquidity have been increased regulations on market makers and a changing market structure.
Extraordinarily easy monetary policy on balance has added to liquidity, and is likely masking the full structural decline in liquidity. This means lower financial market liquidity may become even more apparent when major central banks eventually tighten monetary conditions again.
The banks have noted that the ‘new issue premium’ they pay has generally increased over the past year, as global market uncertainty and volatility has increased, although these costs had been manageable thus far. The increase in cost can be illustrated below, which shows the spread above swap for senior unsecured five-year AA corporate bond yields, a similar type of debt to what banks issue. While there is the potential for liquidity problems to worsen over time, banks are actually in a relatively good position at present with their funding, in large part owing to the Core Funding Ratio regulations. This has meant that banks have a larger buffer in their funding, and if they do miss a window of funding owing to market conditions, then they are less exposed, particularly to rollover risk.
We examined liquidity developments in three key areas of New Zealand financial markets: the New Zealand government bond market, bank funding markets, and short-term money markets. Overall, we found that liquidity has declined across these markets, but to varying degrees. In New Zealand government bond markets, we found mixed evidence for declines in market liquidity, with one measure indicating declines, while others pointed to little change. Nevertheless, market makers we spoke to noted they had seen a decline in liquidity in the market, although had been able to ‘absorb’ it this far, allowing investors to trade as normal.
Nevertheless, risks have risen that additional market makers may choose to participate less in the market owing to an increased regulatory burden, exacerbating poor liquidity conditions further and raising costs for investors and the NZ government.
Funding liquidity in New Zealand’s bank funding market has only modestly diminished over the past year, owing primarily to greater market volatility caused by events such as the Greek crisis in 2015. However, these costs have been manageable thus far, and regulations such as the Core Funding Ratio and more conservative bank risk appetites mean that banks are more resilient than prior to the global financial crisis to shocks to funding markets.
Finally, we identified a notable decline in liquidity in New Zealand shortterm FX swap markets, which resulted in higher volatility and key interest rates being out of line with the OCR for longer. In short-term markets the effect of new regulation has caused some market participants to withdraw. In response, the Reserve Bank has chosen to increase its participation in the FX swap market, which appears to have contributed to an improvement in market conditions.
