The author is president and chief government of the Investment Company Institute
While excessive inflation is making the headlines, one other probably worrisome improvement for markets this yr has been the deterioration of liquidity in buying and selling.
As the US Federal Reserve mentioned in its newest Financial Stability Report in May, liquidity has been falling since late 2021 in US Treasuries in addition to in futures contracts on the S&P 500 index and oil.
Liquidity — measured within the ease with which patrons and sellers can transact — is crucial to a well-functioning marketplace for on a regular basis traders and debtors. Seeing strains throughout these a number of markets must be elevating actual issues.
In truth, underlying structural weaknesses have been evident for a while. This is especially so in wholesale funding markets the place traditionally banks, performing as sellers, have performed a key position in offering liquidity.
More stringent regulatory capital rules adopted in response to the monetary disaster are sometimes cited as making intermediating fixed-income trades extra pricey.
This means sellers are committing much less of their stability sheet to market-making actions. While others — similar to buying and selling companies — could have stepped in to offer liquidity, their aims and incentives are completely different. Now, so as to add to those structural modifications, the Fed is decreasing its Treasury holdings and not shopping for bonds.
To their credit score, policymakers — each within the US and globally — have recognized that there could also be some basic structural points at play in market-making actions. But supposed weaknesses in cash market and open-end mutual funds have additionally been topic to scrutiny.
Policymakers have been trying on the threat that cash market and open-end mutual funds would possibly amplify liquidity shocks — whether or not any benefit in being the “first-mover” in fund redemptions might spur additional promoting or create challenges in offloading property throughout stress.
So we’re seeing a raft of proposals aimed toward cash market and open-end mutual funds to extend liquidity buffers and require measures similar to “swing pricing” which search to cross on a few of the prices of redemptions to the sellers in instances of stress.
Some of this is because of a misreading of the proof from earlier episodes of stress, specifically the occasions of March 2020 when the pandemic induced an abrupt shutdown of the worldwide economic system. The truth is that cash market and open-ended mutual funds weren’t the reason for the March 2020 liquidity disaster, and their supposed position in amplifying the disaster will not be supported by knowledge.
Our analysis reveals funds’ complete internet gross sales of bonds, particularly Treasuries, had been a lot smaller than has been claimed by policymakers. And the timing of bond mutual funds’ each day internet gross sales don’t align with the evolution of the dislocation within the Treasury market on the time. In addition, their small share of Treasury market buying and selling quantity signifies little, if any, amplification of stress.
The principal lesson to be drawn from the expertise of March 2020 is that this: we have to be sure that secondary markets can provide ample liquidity to all when traders most want it.
A menu of promising steps to do that has already been drawn up by policymakers. Ideas embody:
• Modifying the so-called “supplementary leverage ratio” that stipulates how a lot capital banks should maintain as a proportion of their property. This ratio ought to exclude Treasuries and deposits on the Federal Reserve. With better capability on their stability sheets, banks and their supplier subsidiaries could be higher positioned to facilitate trades in bond markets throughout instances of stress. This modification labored properly on a short lived foundation in the course of the Covid-19 disaster;
• Studying the potential advantages of central clearing of buying and selling to cut back monetary establishments’ publicity to counterparty threat. It might additionally increase their stability sheet capability to facilitate buying and selling due to netting, which permits offsetting trades with the identical counterparty;
• Promoting the growth of “all-to-all” buying and selling that permits patrons and sellers to work together with one another immediately with no financial institution as a intermediary. This can take strain off sellers’ stability sheets in instances of stress;
• Evaluating the influence of rules on market contributors that present substantial liquidity and carry out related actions as sellers within the markets.
Taking this agenda ahead requires a sustained, multilateral and multi-sector effort, which policymakers ought to take up without delay. Even although it’s simpler to suggest new guidelines for cash market and open-end mutual funds, these efforts gained’t tackle the liquidity problem. Improving market buildings will.