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Good sellside research is like busses; you wait for ages for something interesting to turn up, and then a bunch rolls into your inbox all at once.
This was the case late last month, when Barclays published the 69th instalment of its annual Equity Gilt Study, with several fascinating chapters. We’ve already written up the sections on the impact of a consolidated tape on European credit and the flood of Treasuries hitting the market, so let’s make it a hat-trick and dive into the chapter on
-cue ominous music-
!bONd MaRKeT LIqUIdiTY!
Barclays:
We expect important parts of the fixed income market to suffer from increased fragility over the next several years. This is really the continuation of a trend, evidenced by two high-profile recent disruptions: the 2019 repo market volatility and the COVID-induced ‘dash for cash’. In fact, the nature of shocks has been worsening since 2016, with both more frequent and more severe disruptions in Treasury and funding markets.
As any reader of the financial press over the past decade will know, this has been a perennially popular topic since the financial crisis, and comes in several flavours (such as corporate bond market liquidity, Treasury market liquidity, or bond ETF liquidity).
The top-level issue that everything flows from is that stricter post-crisis regulations make it much harder for banks to intermediate trading in bonds. Increasingly, they act as pure brokers rather than dealers, due to balance sheet constraints.
At the same time, the size of the bond market has ballooned, because of government deficits and more companies turning to fixed-income markets to borrow (also partly because of tougher regs on banks).
That is a problem when everyone suddenly wants to sell. Banks’ inability to absorb or even modulate any serious selling sprees means that prices can move scarily sharply for an asset class that is supposed to be steadier than equities.
We’ve certainly seen more spikes of violent bond market volatility in recent years, but the big fear is when trading gums up entirely and bond funds suffer a rash of outflows. Unable to liquidate their holdings, widespread fund gating spooks already jittery investors and causes wider carnage.
That is one of the reasons why central banks acted so aggressively in March 2020, and Barclays’ Joseph Abate and Jeffrey Meli argue that this is the way things will be from now on:
We argue that investors and regulators are faced with a trilemma: it is impossible to simultaneously have stable markets and intermediaries and no moral hazard. Pre-crisis, extreme market liquidity came at the cost of highly levered banks and significant systemic risk. The post-crisis efforts to stabilize banks and other intermediaries have improved the situation overall, but reduced the stability of markets. Further, pre-crisis intervention to stabilize banks has been transformed into post-crisis official interventions to support market functioning, introducing a new form of moral hazard. The natural response is to layer new regulations, but we suspect there is no ‘silver bullet’ combination of rules and structures that will solve this trilemma.
This not to argue that the new framework is poorly designed or mistaken. Instead, regulators are fighting an uphill battle: a framework that is effective in a $20 trillion market may not be adequate for a $40 trillion market. In fact, the real source of the trilemma may be a reduced tolerance — from investors, intermediaries, and, most importantly, central banks — for market instability. This intolerance is not from a lack of nerves: liquid and well-functioning Treasury and funding markets are essential for the efficacy of the post-crisis reforms. If we are correct, the cycle of disruption, intervention, and regulatory innovation will continue for the foreseeable future.
This is admittedly mostly a new framing of a now-mainstream observation: in today’s financial system central banks increasingly have to dealers-of-last-resort in addition to lenders-of-last-resort. Even the BIS — often the high priest of financial orthodoxy — has grudgingly accepted this.
But Barclays has gone deep with this report, zooming in on how the interaction of two separate issues — the supplementary leverage ratio and Intermediate Holding Company rules — has “changed the nature of shocks”, detailing how funding market disruptions can reverberate, and discussing the impact of possible policy measures like easing the SLR or introducing central clearing.
The report is one of the better, more thorough examinations we’ve seen for a while, so we asked Barclays if they could make it public for FTAV readers.
Thankfully, they have, so you can read the full thing here.
The whole thing is worth reading, but here is the kicker:
The fear of disruption is, at least in part, justified. The linkages between intermediaries and investors have become more complex over the past several decades, meaning that stress can propagate in unexpected ways through the system, as demonstrated by the events leading up to the financial crisis.
Further, the size and importance of the Treasury and funding markets has grown, and Treasuries and other high quality assets play a more prominent role in the regulatory framework. Both factors have increased the consequences of disruptions. For example, the efficacy of ratios such as the LCR is wholly dependent on liquidity in those instruments. A dysfunctional Treasury market would pose a challenge to the entire post-crisis approach to liquidity regulation.
However . . . the downside of a bubble-wrapped market is moral hazard, where intervention suppresses the consequences of liquidity and financing risk, or even (based on recent events) interest rate risk, and where investors and intermediaries position accordingly, raising the frequency of disruptions.
