After a decade of central bank policies pumping liquidity into markets, many investors have come to underappreciate liquidity risks. As these can be the hardest to see beneath the surface of normal, well-functioning markets, they are easy to ignore and often aren’t recognized by investors until it’s too late. The changing role of intermediaries since the financial crisis has exacerbated liquidity risks, and investors can proactively address these issues before illiquidity strikes again.
History Replete with Liquidity Crises
One doesn’t have to look back far to find that financial history is replete with liquidity crises. As recently as 2008, widespread liquidity shortages forced market participants to liquidate assets resulting in the failure of banks, insurance companies, and other financial institutions. Many asset managers became forced sellers to meet outflows and margin calls, and vanishing liquidity exacerbated the momentum behind already falling prices.
These experiences of illiquidity are clear in hindsight but less so before they occur. That’s because while market risk can be explained by fluctuations in price, liquidity risk isn’t necessarily incurred until assets are traded. As a result, investors often fail to identify a problem until it’s too late and omitting liquidity risks has been shown to overestimate a portfolio’s value by as much as 22%.1
Changing State of Liquidity
Fed policy did little to address fundamental issues of illiquidity following the market dynamics of 2008, and in many cases only temporarily increased the demand for financial assets. New technology has created the appearance of increased liquidity through breadth and information, but changes in market structure and the role of intermediaries have had a significant negative impact on depth in the marketplace.
A key reason that liquidity manifests itself differently in fixed income versus equities is that the bond marketplace is primarily over-the-counter and not exchange-traded. In polling the heads of the largest sell-side market dealers, we found that 85-95% of bond market liquidity is still facilitated by securities dealers whose role is changing with regulation. While they still act as agent in matching buyers and sellers, their ability to warehouse risk and act as a principal when facilitating these transactions is now limited by regulation.
By definition, dealers are not long-term investors in markets. Therefore, the availability of liquidity is not indicative of long-term supply and demand, and bids/offers are not a reliable indicator of the fundamental value of fixed income securities. End buyers and sellers, such as asset managers and hedge funds, are the ultimate supplier of liquidity in this system, and it is the demand and supply from these investors that set price equilibrium levels.
New Liquidity Dynamics
Leading up to the last financial crisis, the environment was markedly different, with large investment banks acting as primary providers of liquidity. The 2007-2008 experience resulted in the disappearance of large investment firms, such as Bear Stearns and Lehman Brothers, and the passage of tighter regulatory requirements in the form of the Dodd-Frank Act and Basel III. In the time since, we’ve seen decreased liquidity in fixed income markets as a byproduct of this industry consolidation, stricter regulatory oversight and increased capital requirements. The remaining dealer trading operations are generally defined with a more narrow focus on facilitating trades through taking temporary positions in securities.
As a result of the reduced participation by dealers and inability to risk proprietary capital, liquidity relied on in the past for many instruments will no longer be there. It’s reasonable to expect liquidity to be compromised in the riskier and more complex segments of fixed income markets - these could include high yield, emerging markets, and structured securities (such as CMBS and non-agency RMBS). On the other side of the spectrum, higher-quality, lower-risk fixed income sectors should be less affected as demand for these assets should also remain high in the event of another crisis.
The timing for our next financial crisis is, like the last, highly uncertain. With this, it is highly unlikely that anyone will predict exactly when the next bout of illiquidity will occur. Instead, investors can be prepared by taking a deeper look at their holdings and focusing on higher quality, lower risk fixed income instruments with the ability to withstand the next liquidity crisis whenever it may come.
By Mark Landis, Co-Founder & Timothy Yan, Managing Director
1 Bangia, A., Diebold F. X., Schuermann T. and Stroughair, J. D. (1999). Liquidity on the Outside. Risk, 12, pp. 68-73
