IDEAS FIXED INCOME

March 2016
Intended for professional clients

Liquidity risk in the Fixed Income Markets

KEY ELEMENTS faced with unusual risk/return profile in sovereigns amid
restructuring risk
Liquidity is a complex and multiform concept whose dimensions are
difficult to capture in a single measure
Current conditions i.e. low interest rates and the accommodative
monetary policy, have failed to maintain high level of market liquidity
The major changes in the regulatory environment that have occurred
since the financial crisis have had an important impact on liquidity

buy goods and services in the real economy.

Liquidity in the financial markets Compared with a purely bank-based financial
What is liquidity? system, financial markets provide investors with
access to broadly diversified underlying portfolios. As
From a broad economic perspective, liquidity is liquid markets are easily accessible, risks are spread
the ability of economic agents to exchange their across a large number of investors, thus helping to
goods into wealth. Liquidity is thus a flow notion promote financial and economic stability. A shortfall
(as opposed to the notion of stock). Illiquidity in liquidity might result in credit rationing and thus
arises when it becomes difficult or impossible to less funding available for investment, regardless of
exchange assets. When there is not enough how profitable the investments may be.
money in an economy, transactions and thus
activity slow down. Liquidity is diminishing

From a market perspective, investors are Despite accommodative monetary policy -

concerned with asset liquidity, which is generally characterized by low rates and quantitative easing -
defined as the ease with which large quantities and the emergence of electronic platforms, current
can be traded rapidly, at any time, and at a low market evidence points to a significant reduction in
cost. There are thus four interrelated dimensions market liquidity. Evidence suggests that market
of liquidity: width measures the costs incurred depth has been significantly reduced as it is
as the result of a round trip transaction e.g. by becoming difficult to execute large orders without
instantaneously buying and selling a security; impacting prices, pushing market participants to
depth is the number of shares that can be divide their trades up into smaller orders. In the US,
traded at a given price without incurring dealers’ inventories of corporate bonds declined by
additional costs above the bid-ask spread; 60% between 2008 and 2015. Over the same period,
immediacy captures how quickly positions can banks’ trading capacity reduced by 40%. A similar
be traded and corresponds to the time between pattern has been observed in the European corporate
placing the order and settlement; resiliency market: according to PwC’s Global Financial Markets
indicates the ability of the market to absorb Liquidity Study of August 2015, trading volumes
random shocks (e.g. uninformative orders). declined by 45% between 2010 and 2015.

Why is it important? As policy decisions are transmitted to the real

Financial markets make it possible to slice risk up economy via markets, central banks pay a great deal
into different types (e.g. interest rate, credit, of attention to how the markets function. The ECB
currency) and to distribute it in order to promote conducts regular surveys of market participants. The
efficient funding for investment in the real 4Q15 securities market survey revealed considerably
economy. Efficiency lies in both the broad range lower liquidity in markets where the ECB has
of assets available for savers and the low conducted asset purchases. Indeed, as can be seen
execution costs for funds to be transferred to in the chart below, perception of liquidity in the
would-be borrowers. market for covered bonds started waning as soon as
the CBPP3 1 was launched. Similarly, the start of
Liquid markets ensure that assets can be
converted into cash, which can then be used to 1
The ECB’s Covered Bond Purchase Programme launched on 4
September 2014

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PSPP2purchases coincided with gradually weaker activities on any one issuer and the overall
liquidity conditions across the euro sovereign size of the trading book. A similar rule is
debt markets. likely to apply in Europe at some stage;
• the bank separation rules, which oblige
banks to separate out their market-making
activities. Because the market-making
entities are necessarily smaller, their funding
costs are likely to be higher, thus increasing
the cost of holding a large trading book;
• Bank Recovery and Resolution plans
which require the banks to hold a minimum
amount of long-term assets in order to
constitute their “loss absorbing capacity”.
These plans, plus all the new capital
requirements, restrict the amount of capital
available to hold against trading activities.

Why is it diminishing? Securities lending and repo markets are an

important source of liquidity and short term
The impact of regulation on market liquidity
funding. A reduction in liquidity in these markets
New regulations were clearly needed to address affects liquidity in other capital markets.
the issues that arose during the 2008 financial Previously, these transactions consumed very
crisis. However, there is a growing realization
little capital as they were fully collateralized.
that the regulations came so thick and fast that
not enough thought was given as to how they Under the new regulations, the leverage
interacted nor to their unintended consequences. requirements do not take into account collateral
Among other things, the new regulatory or the creditworthiness of the counterparty, thus
framework has reduced liquidity in various significantly increasing capital. In addition, banks
markets by impacting banks’ trading books, the are all chasing the same high quality assets
securities lending and repo markets, the which can be used as collateral for both these
derivatives markets, trading in smaller names
transactions and for derivatives, and as capital.
and the number of players in the market.
If less eligible collateral is available, it makes it
The regulatory changes that impact banks’ more difficult to trade.
trading books include:
• The increase in capital on the trading Derivatives transactions are often used to hedge
book and the new leverage, liquidity and market positions. If it becomes more difficult to
net stable funding ratios (Basel 2.5 and hedge, it becomes more difficult to take the
3). Before the financial crisis, the capital market position, again reducing liquidity.
on trading book assets was considerably Derivatives have become more expensive
lower than for banking book assets. This because of the cost of clearing and increased
is no longer the case. In fact, capital capital costs. Moreover, the different clearing
increases have probably been the requirements in the US and Europe are causing
greatest in the trading book, making it market fragmentation: the same product is
very expensive to maintain large trading at different prices on either side of the
positions; Atlantic.
• Single counterparty credit limits
Under MiFID and MiFIR, ESMA’s definition of
which limit the exposure a bank can hold
“liquidity” is likely to result in illiquid instruments
on any one entity. The limits take into
being classified as liquid and thus subject to the
account exposure on entities in the
trading book; pre- and post-trade transparency requirements.
This discourages market-makers from trading on
• the US Volcker rule, which is ambiguous
as to whether holding large positions in a less liquid names.
particular issuer in the trading book
Globally, the increased cost of compliance and
might constitute “proprietary trading”,
reporting is forcing smaller players to exit certain
thus inciting dealers to restrict their
markets, thus depressing liquidity still further.
2
The ECB’s Public Sector Purchase Programme launched on 9
March 2015

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Coping with liquidity risk year bond is not the same as the liquidity of a 3
month bond of the same issuer. Secondly, measuring
Impact on investors: cost, opportunities and liquidity on the basis of traded volumes can be
bubbles misleading as a traded bond is not necessarily liquid
The term “liquidity risk” conjures up notions of e.g. forced selling and falling angels. In addition,
cost and loss. The cost of liquidity when trading bonds that are not traded are not necessary illiquid.
an asset is typically captured by the bid-ask Dastidar and Phelps (2009) invented the liquidity
spread. The components of liquidity cost are cost score (LCS) to measure bond liquidity. A bond’s
threefold. Direct trading costs are deterministic LCS represents the round-trip cost, as a percentage
transaction costs encompassing brokerage of the bond price, of immediately executing a
commissions, transaction taxes and exchange standard institutional transaction. A lower LCS value
fees. Price impact costs correspond to the denotes better liquidity.
difference between the executed price and the
mid-price. It is generally limited to half the bid- While the LCS focuses on the cost dimension of bond
ask spread for small orders but can exceed the liquidity, the price sensitivity of a corporate bond to
bid-ask spread for larger positions. When trading transaction volume is captured in a separate
a small position, usually the order can be measure called the Price Impact Measure (PIM). The
executed at the best price with a single PIM measures the ratio of a bond’s daily absolute
counterparty. As the size of the position excess return (net of the Corporate Index excess
increases, a number of counterparties are return) to its daily dollar volume of transactions.
required in order to absorb the order, each with
Bonds with higher spreads and durations have higher
different beliefs about the fair value of the asset,
LCS and PIM.
which can push the price down. Search and
delay costs are incurred when traders delay
execution in order to search for a better
execution price than the price “indicated” by the
bid-ask spread. By doing so, traders take the risk
of seeing the market move by the time they
decide to execute their order. This trade-off
between price impact costs and seeing the
market move is particularly relevant for block
orders.
More generally, a drop in liquidity limits the
efficiency of the market and increases the cost of
funding, leading to forced selling, deleveraging
and unwinding of positions. Moreover, liquidity
risk can spread to the whole market. For
instance, other asset classes can be affected by The Trade Efficiency Score (TES) complements the
funding risk: when the banks’ margins rise or LCS and PIM by ranking corporate bonds with both
when a bank goes into bankruptcy because of their LCS and traded volumes. This relative liquidity
difficulties affecting a single type of asset, measure is useful for identifying the most liquid
investors find it difficult to fund other kinds of bonds in a bucket of securities.
investments. This was clearly demonstrated
How do asset managers manage liquidity risk
when the US housing bubble burst.
for their clients?
Liquidity also plays a predominant role in the
Liquidity risk ranks high among the risk factors
development of crises and the bursting of
affecting the P&L of a portfolio. It is taken into
bubbles. The concomitance of bubbles and
account in the portfolio construction process in
liquidity is well documented in academic papers.
addition to strategic allocation, market opportunities
Investors expect to be compensated for bearing and investors guidance. These measures have been
liquidity risk, which can push prices down. recently complemented by new practices such as
Academic and professionals estimate liquidity risk swing pricing.
premiums at around 0.6% for investment grade
bonds and 1.5% for speculative bonds.
How to measure liquidity in Fixed Income Portfolio construction: monitoring turnover, an
markets? illiquid strategy bucket and the risk-return
trade off
Extending liquidity measures traditionally used in
the equity markets to bond markets is not Unlike other risk factors, liquidity risk cannot be
straightforward, for at least a couple of reasons. diversified. For example, one cannot offset a given
First, the liquidity of a bond depends on the level of liquidity “exposure” by going short an illiquid
bond’s intrinsic characteristics. Unlike shares, security. No known liquidity-based derivatives hedge
bonds redeem at maturity. The liquidity of a 10

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this particular risk. Indeed, in stressed markets, predefined swing factor. Subscribers thus contribute
bid rather than mid prices prevail. to the cost that their transactions generate by
entering the fund at a higher price, while
However, illiquidity generally occurs over the
redemptions are executed at a lower price. The
short term but vanishes over the long term: a
swing factor and threshold level are reviewed on a
security held to maturity has no liquidity cost.
regular basis by a committee dedicated to validating
Given that, the asset manager can adapt the the parameters of the swing pricing.
risk-return profile of the portfolio by strategically
Swing pricing does not generate additional costs for
allocating certain assets to the illiquid strategy
holders; it modifies the allocation of costs among
bucket e.g. private debt. Such a bucket helps to
shareholders. Nonetheless, the mechanism may
boost the overall return of the portfolio by
generate volatility in daily prices, thus increasing the
capturing an extra premium while offering
tracking error or the volatility of the fund,
potential diversification benefits.
irrespective of any fundamental change in the
Illiquidity increases with the size of the position. inherent risk of the portfolio.
As a result, even for liquid strategies, turnover
Conclusion
has to be closely monitored and trading
strategies balanced against potential liquidity Liquidity conditions in financial markets
costs before the strategy is implemented. This is are among the main concerns for investors
even more critical for illiquid strategies. For at present. Liquidity represents the ability
instance, a breakeven yield, compensating for to trade rapidly large amounts of
taking into account transaction costs, can be securities with minimal impact on market
calculated for a strategy or issue by issue. prices. The recent evolution of the
regulatory framework has reduced the
Swing pricing
ability of banks to maintain market-
Swing pricing aims to protect the overall making activities with negative
performance of the portfolio for the benefit of consequences on the functioning of
existing investors. markets. These changes have forced asset
Trading activity incurs costs (brokerage fees,
managers to measure liquidity risk more
liquidity spread, taxes) that are traditionally
accurately and to take it into account in
charged to the fund and thus dilute the value of
their investment processes while adapting
existing investors’ investments.
asset allocation modelling. The protection
of investor interests in funds required the
Swing pricing is a mechanism by which the NAV introduction of swing pricing to better
of a fund is adjusted upwards in the case of large distribute liquidity costs across
net inflows and downwards in the case of large shareholders.
net outflows. Namely, if there are important
subscriptions or net inflows (or redemptions or
Dated 16 March 2016
net outflows) exceeding a certain threshold, the
NAV will be swung upwards (or downwards) by a

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