Macaskill on markets: Liquidity drought’s conflicted Cassandras

Jon Macaskill
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It is now a mark of the serious individual in finance to issue a dire warning about the threat posed by a lack of market liquidity. What climate change is to the young liberal (or young person), so liquidity has become to the ageing plutocrat, secure perhaps in his own billions, but with a furrowed brow as he contemplates the potential havoc that could be wreaked by diminished liquidity.

Blackstone CEO Stephen Schwarzman in June joined the list of alarm sounders, with an op-ed article in the Wall Street Journal entitled “How the Next Financial Crisis Will Happen”. He noted the sharp, albeit brief, dislocation in US Treasury prices last October and a Deutsche Bank report that dealer inventories of corporate bonds have fallen by 90% since 2001.

This led Schwarzman to a seemingly inescapable conclusion: “A liquidity drought can exacerbate, or even trigger, the next financial crisis.” He then outlined the likely consequences: “Sellers will offer securities, but there will be no buyers. Prices will drop sharply, causing large losses for investors, pension funds and financial institutions. Additional fire sales will aggravate the decline.”

Schwarzman did not specify whether plagues of frogs or swarms of locusts would come next in his vision of the financial market end times, but there are only so many baleful warnings you can cram into a single thought piece.

There will be some who say that Schwarzman, the billionaire founder of a private equity firm, has a track record of making absurd predictions about the threats posed by any changes to the regulatory and investing framework that has served him so well through the years.

This, after all, is the man who in 2010 compared the potential removal of the carried interest tax loophole for private equity investors to Hitler’s invasion of Poland. The tax exemption for private-equity earnings remained intact after effective industry lobbying, so we will never know whether its removal would have had an impact comparable to the start of a world war. But we can probably agree that Schwarzman is prone to hyperbole, if not actual hyperventilation.

This is not to dismiss his concerns about the threat posed by illiquidity entirely. There is no question that there has been a reduction in bond market liquidity across different instruments since investment banks reacted to the approaching Volcker Rule on risk taking by slashing their proprietary trading activity.

And a multi-year rally in both bonds and equities clearly raises the chances of big reverses, whether the catalyst is a Greek euro exit or higher US rates.

There are legitimate questions to be asked about the motivations of both the buy side executives currently sounding the liquidity alarm, and some of the dealers echoing their fears, however.

One query should be whether they are simply weighing in on a political debate as part of a broader push to reverse the increased regulation imposed after the 2008 crisis. Schwarzman’s call for a “fresh look” at the Dodd Frank banking reform laws passed in the US in 2010 certainly fits that bill.

Recent interventions by Gary Cohn, president and CEO-in-waiting at Goldman Sachs, were questionable in a comparable but different way.

Cohn weighed in on the issue of potential unintended risks (these are the bad types of risk) from mandating that complex, illiquid products be centrally cleared. He was addressing a genuine concern about the robustness of the clearing houses that have become newly important since regulators determined that most derivatives should be cleared.

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Macaskill on markets

It is difficult to escape the suspicion that Goldman Sachs, which has long been a leader in trading complex, illiquid products, scents an opportunity from the current debate over liquidity and market structure to slow down any erosion of its competitive position, however.

Cohn’s other warnings – that he is concerned about overall market liquidity and fears that investors are not sufficiently prepared for the effect of a Federal Reserve rate hike – also seemed disingenuous.

A bout of bond market volatility that resulted in forced cash sales and derivatives hedging by asset managers and others, rather than the recent trend of sharper price swings without exceptional volumes, would suit Goldman just fine.

The bank has committed itself to a business model that is reliant on trading revenues, so a bout of volatility (the good type, that doesn’t spark any awkward questions about investment bank counterparty credit quality) would be very welcome.

Some investment bankers go further and say privately that a serious market disruption would be a good thing, as it might prompt a reversal of the trend toward tighter regulation that has been seen since 2008. This may be a minority opinion, given that memories of the collective near-death experience for the industry remain relatively fresh, but it reflects a widespread view that supervisors should have to abide by the Pottery Barn rule that US secretary of state Colin Powell is said to have used to express concern on the eve of the US invasion of Iraq in 2003: If you break it, you own it.

The Pottery Barn rule in a financial context could mean that if supervisors ‘break’ the markets with new rules that reduce liquidity, then they should feel obliged to respond to any liquidity crisis by rolling back regulation.

Central bankers are understandably not impressed by this argument and their own industry club – the Bank for International Settlements (BIS) – devoted space in its annual report released on June 28 to discussing the issue of liquidity.

BIS divided liquidity into two types: structural issues relating to order matching; and persistent order imbalances when investors all head in the same direction. In analysing structural liquidity,  BIS acknowledged that changes in regulation had affected dealer approaches to market-making and that there is now bifurcation in the debt markets, with liquidity concentrated in actively-traded government securities such as Bunds and Treasuries at the expense of corporate bonds and emerging market debt.

But in its discussion of order imbalances the BIS took square aim at the asset management industry, which has been giving the impression that liquidity problems are all someone else’s fault and battling mightily to resist increased supervision.

“The growing size of the asset management industry may have increased the risk of liquidity illusion: market liquidity seems to be ample in normal times, but vanishes quickly during market stress,” BIS said, noting that asset managers and institutional investors were less well placed to play a market-making role at times of large order imbalances.

BlackRock, Pimco and other big asset managers can consider themselves warned, as can Blackstone’s Schwarzman: regulators are also examining the potential for a liquidity drought but do not seem inclined to shoulder the blame if there is any serious market disruption.

To adapt the words of the late, great rhinestone investor Elvis Presley, asset managers might want to try a little less conversation and a little more action, whether it is in the form of liquidity sponsorship or plain old diversification.