A new BIS paper illustrates how debt and collateralization create liquidity. In particular, money markets rely on excessive and obfuscated debt collateral to contain information costs. Opacity and “symmetric ignorance” support their smooth functioning. The flipside is that large negative shocks to collateral values inevitably catch markets “uninformed”, disrupting liquidity services.
Market liquidity measures the cost efficiency of trading. Liquidity risk refers to the probability that these costs surge when trading is required. Liquidity and liquidity risk are major factors in the long-term performance of trading strategies. The apparent inverse relation between liquidity and expected returns also offers obvious profit opportunities. There are various conceptual solutions for measuring market liquidity timely.
A new CGFS study suggests that [i] bond market makers’ risk tolerance and warehousing have declined and [ii] tighter risk management has augmented pro-cyclicality of liquidity. A gap seems to have opened between more precarious liquidity supply and more voracious liquidity demand, due to rising assets under management at funds that allow daily redemptions.
Developed market government bonds are viewed as “safe havens”, but in reality they have been prone to sudden outsized price declines, similar to FX carry trades, even during the past 20 years of modest inflation. Drawdowns are worse in poor liquidity. This empirical finding is not new but more relevant as bond yields have been compressed and institutional duration exposure has surged relative to banks’ market making capacity.
A new IMF policy paper defines global liquidity as the ease of funding in global financial markets. The concept is useful for understanding the commonality in global financial conditions, with four large financial centers dominating the world’s institutional funding. In the 2000s banks have been the main conduit of financial shock propagation, but asset managers may play a greater role in the 2010s (see also posts here, here and here).
Modern physics teaches that objects behave differently as they reach the speed of light. This has become relevant for financial market execution. While prices pretend to be global, in reality they depend on location. Liquidity at any given price is uncertain. And physical location becomes critical for the success of certain trading styles. Moreover, quantum physics suggest that ‘freak events’ that destabilize the markets are likely to occur.
A brief speech by ECB governing council member Benoît Cœuré summarizes problematic side effects of increased central counterparty clearing in derivatives markets. Systemic threats may arise from unprecedented risk concentrations in a few global central counterparties and participating banks, as well as from the mutualisation of losses and liquidity shortfalls across systemically important institutions.
A paper of the University of St. Gallen shows that foreign exchange liquidity has been highly correlated across currency pairs, apparently more so than in equity markets. Liquidity correlation has been strongest in developed FX markets and particularly in volatile currency pairs. Bond and equity markets seem to have a bearing on systematic FX liquidity. Feedback loops between market illiquidity and funding constraints can escalate into fire sales. Riskier currency pairs, and particularly those related to carry trades, are more susceptible to liquidity shocks.
Even in a huge market like U.S. fixed income, dealer balance sheet management these days can impair liquidity. New Federal Reserve research suggests that during the 2013 treasury sell-off dealers reduced their own positions rather than absorbing client flows and decided to limit their market making.
A Bundesbank working paper provides evidence that Credit Default Swap (CDS) spreads change significantly in accordance with (i) the direction of order flows, (ii) the size of transactions, and (iii) the type of counterparty. Apparent causes are asymmetric information, inventory risk and market power. The implication is powerful. Since transactions do not require commensurate changes in fundamentals and since CDS spreads are themselves used for risk management, institutional order flows can easily establish escalatory dynamics.
Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.
