When Citigroup chief government Jane Fraser was requested earlier this week what dangers she was most involved about, market liquidity topped her checklist.
The Financial institution for Worldwide Settlements is apprehensive about “fragility” out there for mortgage-backed securities. And volatility has soared in US Treasury markets this autumn as a consequence of poor liquidity.
With the world poised to plunge into recession, stresses are to be anticipated. However there’s rising proof that the post-crisis reforms, whereas geared toward shoring up monetary stability might have, in essential areas, merely traded counterparty threat for liquidity threat.
Again within the 2008 disaster, a lot of the contagion stemmed from trades between failing establishments and stronger ones. When insurer AIG offered extra credit score default swaps than it might make good on, its failure threatened to topple a complete slew of banks that had been on the opposite aspect of these trades. Equally, the collapse of Lehman Brothers inflicted destabilising losses on cash market funds that held its debt.
Since then regulators have focused on ensuring particular person banks are stronger and fewer weak to troubles brewing in much less regulated elements of the monetary sector, identified collectively as shadow banks. Extra transactions now run by means of central clearing homes or require extra collateral. The thought is that if one aspect will get into hassle, the opposite aspect isn’t left holding the bag.
To a big extent they succeeded. International banks are a lot better capitalised than they as soon as had been. Many transactions, together with these involving advanced derivatives, have shifted from what was primarily unsecured lending to margin-based preparations backed by money or secure, easy-to-sell property.
However that has not all the time translated into the broad monetary stability policymakers had hoped for. Mass promoting within the early days of the Covid-19 pandemic pressured the US Federal Reserve to backstop each cash market funds and the marketplace for industrial paper.
Extra lately, the London Metallic Trade in March shut buying and selling and cancelled billions of {dollars} in offers as a result of surging nickel costs had inflicted a $2.6bn loss on the clearing home it had set as much as attempt to cease contagion. Then in September, the Financial institution of England was pressured to intervene when pressured promoting to satisfy margin calls destabilised the UK gilt market.
“We’re seeing liquidity strains in locations that my era of central bankers wouldn’t have anticipated, and hoped to forestall by constraining shadow banking,” says Paul Tucker, the previous BoE deputy governor who helped lead the UK response to the 2008 monetary disaster.
The displacement of counterparty threat into liquidity threat comes from a number of sources. In Treasury markets, Wall Avenue banks used to play a crucial warehousing position, notably within the short-term lending “repo” market. However more durable capital guidelines have led them to prioritise different, higher-margin enterprise strains, and different market individuals have proven no indicators of moving into their sneakers. As an alternative, when volatility rises, hedge funds and high-frequency merchants step away from their keyboards.
“Vendor banks at the moment are pushed by revenue per unit of stability sheet and repo isn’t on the prime of the checklist,” says the IMF’s Manmohan Singh. “They’re judged on share value not on whether or not they assist with the US treasury markets.”
The emphasis on collateral has additionally contributed to instability in ways in which policymakers didn’t anticipate, most notably by amplifying promoting stress. The UK gilt market meltdown is a primary instance: UK pension funds had purchased derivatives as a part of a technique referred to as liability-driven investing. When gilt costs fell sharply, they obtained margin calls requiring them to publish extra collateral, so that they offered gilts, additional driving down the worth, resulting in extra margin calls.
A 3rd form of illiquidity has emerged in recent times as traders moved past financial institution accounts, shares and bonds in the hunt for increased returns. In occasions of market turmoil, funds targeted on actual property, non-public credit score and the like have been hit by extra redemption requests than they will simply deal with. Blackstone lately restricted withdrawals from its $69bn Breit non-public actual property fund after breaching month-to-month and quarterly limits on redemptions.
Bankers argue that a method to assist can be to deal with authorities bond holdings extra leniently in capital calculations however that might encourage lenders to recreation the principles and reawaken counterparty threat. Some regulators need to tighten the scrutiny and collateral guidelines for nonbanks, however that might exacerbate pressured promoting throughout market downturns.
With financial stress rising, policymakers are working out of time to seek out the appropriate trade-off between sources of threat.
