Is liquidity running dry in global financial markets?
This question was the basis for discussions at an ECMI-CEPS lunchtime meeting held on November 20th at which PwC presented the main findings of their recent Global financial markets liquidity study. In its review of liquidity trends and prospects across a broad range of financial instruments and issuers, using a series of liquidity metrics, such as tightness, depth, breadth, resilience and immediacy, PwC found that some markets remain as liquid as before the financial crisis, whereas fixed income markets, especially in corporate bonds, also reported recent deterioration. The overall analysis, which took into account structural, cyclical and regulatory factors, pointed towards continued downward pressure on market liquidity in the coming years. In general, it was found that most market participants are experiencing, and consequently adapting to a more difficult environment for market liquidity, with reduced bank trading activity in fixed income, evolving market structures and new trading behaviour.
With reference to a liquidity risk assessment recently performed by ESMA (European Securities and Markets Authority), it was reported that market volatility went down across many asset classes in the post-crisis period until mid-2014, when the trend was broken. Nonetheless, the cause is very difficult to establish given the confluence of multiple factors and the emergence of sudden market events.
All panellists agreed that banking and capital markets regulation will play a significant but not definitive role in the near future. Fundamental structural changes are underway and will continue. Market liquidity risk is also partially masked by extremely loose monetary policy but this has the potential to change dramatically once monetary conditions return to normal.
With respect to market-making, it was argued that the business model is currently under stress and that trading platforms are effectively competing through technology and innovation with the traditional providers of these services. On the impact of pre- and post-trade transparency on liquidity in the fixed income space, it was stressed that replacing the request-for-quote (RFQ), which is the dominant trading method in fixed income, with the central limit order book (CLOB), the dominant trading method in equities, would not work as swiftly in practice as one would expect.