IIAC head warns on bond market liquidity

IIAC head warns on bond market liquidity

IIAC head warns on bond market liquidity The esteemed and respected head of the Investment Industry Association of Canada, Ian Russell, recently distributed a communique about trends and developments in existing bond markets. One disconcerting notion: There is a real and growing worry that liquidity in modern bond markets is drying up.

Russell recently attended the annual conference of the International Capital Markets Association. Returning to Canada he penned a letter, Building Bond Market Liquidity in Europe, suggests shifts in banking regulations have had the worrisome effects

New capital rules that came in post-2008 crisis require banks hold more assets on the bottom line as a way of providing stability. But the new regulations have introduced a new uncertainty into markets—because it is harder for banks to maintain large inventories of bonds necessary to play the role of market maker, fewer banks are trading bonds. This has a negative effect on market liquidity. Fewer firms are carrying out traditional market-making roles, liquidity in global bond markets is drying up. 

In an interview with Wealth Professional Russell explains the shifts occurring. “It's a combination of different factors. A lot of this is regulatory uncertainty,” he says. “It is most pronounced in Europe. But it is happening everywhere. Market makers, have to carry large inventories. Banks don't have as much capital because of regulations, and so they are giving up that role." Firms are less reluctant to hold bonds. The average hold period is lengthening.“This is worrisome on a couple of levels. “This is going to result in a system that is tougher to trade in. Secondary markets are not as deep and liquid as they have been,” says Russell.

The new, and lower, liquidity will affect issuance. Bond yields will be pushed up. Ultimately, there will be greater market volatility. In the past, banks, acting as market makers, would buy and sell bonds as a way of providing depth and liquidity in markets. Investors knew they could trade in or out of a position because of the market makers. Because it will be tougher for market participants to trade in and out of market, market volatility is amplified. Market shocks will spread faster, easier, will not be absorbed as easily as in the past “Markets can't absorb shocks as well. When there are lots of buyers...shocks can be absorbed. But with less liquidity the shocks are stronger. Market functions are made more difficult, financing is affected,” says Russell.

​As it is, rates low, good environment so has not been an issue yet. But the potential consequences emerged last week notion came to a fore last week when a bank in Portugal experienced difficulties. What was a small shock was something more substantial shock, as lower bond market liquidity amplified the shock.In an era when it is assumed there is a significant market shift coming as interest rates begin to rise is an interesting question, the prospect of increased volatility is worrying. “We have to be prepared for when the in our markets. Markets could be more susceptible to shocks. We just have to get used to this,” says Russell, with an admirable stoicism.