Lack of secondary market liquidity exacerbates sell-off
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Lack of secondary market liquidity exacerbates sell-off

As equity markets have sold off and investors rushed into risk-free bonds, even supposedly liquid US treasuries have seen prices gapping. As volatility rises and investors focus on grim fundamentals, they see a broken bond-market structure.

Amid the market turbulence this week as investors panicked about slowing growth in Europe and around the world, equity markets sold off sharply and panic-buyers drove down 10-year US treasury yields, market sources reported surprisingly thin liquidity, even in benchmark US government bonds. 

With dealers unwilling to position risk ahead of Fed stress tests and amid heightened regulatory reporting requirements on Volcker rule compliance, even in the supposedly most liquid bond markets prices gapped around.

Nick Robinson-large
 Several crossing networks have sprung up, but to succeed they need a critical mass of clients while the market remains fragmented

Nick Robinson

Harvey Schwartz, chief financial officer of Goldman Sachs, reviewing the impact of Volcker rules and increased capital charges on liquidity provision as US regulators now require more detailed reports from US banks, says: “I'm talking about [in] normal market functioning times, not in stress market functioning times, definitely balance sheet has felt scarce. And I think under periods where clients want more liquidity, it may be more difficult to find.”

This is the fear now gripping investors, that the long talked about decline of banks’ traditional market-making capacity as a shock absorber in less liquid credit markets might turn a sell-off into a meltdown, possibly even of systemic proportions.

RBS recently surveyed 65 investors, including asset managers, hedge funds, insurance companies, private banks and others mainly based in Europe and the UK. Of these, the overwhelming majority (84%) sees lack of liquidity as a potential systemic risk for credit markets. Most say it is likely to get worse and while they are trying to manage liquidity risk, there is little consensus on how to do so.

Alberto Gallo, head of European macro credit research at RBS, argues: “Credit markets may have outgrown dealers’ capacity to trade risk. We have now nearly $7.7 trillion of credit in the US, versus $22 billion of inventories on trading desks, the lowest ratio in history. 

"It is harder and more expensive to trade corporate bonds: liquidity is down roughly 70% since pre-crisis.”

Structure 'broken'

Investors have been complaining for more than two years that the bond market structure is broken. Many new initiatives are under way to improve liquidity by better linking holders of bond inventory and introducing new trading protocols, but the market structure is still in flux as volatility rises.

“The Fed data suggest that the volume of corporate bond inventory the sell-side holds is about a fifth of what it was before the crisis,” Nick Robinson, head of trading, fixed income at Schroders, tells Euromoney. “And the US corporate bond market has approximately doubled in size in that time. 

"There have been lots of initiatives to try to address that. Many new agency brokers emerged very quickly – and subsequently disappeared – after Lehman collapsed. More recently, several crossing networks have sprung up, but to succeed they need a critical mass of clients while the market remains fragmented.”

Another investor tells Euromoney: “Banks have very little inventory or balance-sheet capacity. At the moment there is a kind of spurious agency model with a bit of balance sheet behind it and a lot of smoke and mirrors.”

In its November edition, Euromoney will report on the present state of liquidity in the bond markets and new initiatives under way between banks and investors to improve matters.

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