FCA paper: Bond liquidity has improved since 2008
A paper published by the FCA has challenged conventional wisdom by suggesting the level of UK corporate bond market liquidity may have increased, rather than decreased, in the years since the financial crisis.
An occasional paper on the subject, published today by the regulator (March 17), acknowledged bond markets “pose specific liquidity challenges for investors”, but asserted liquidity in the UK corporate fixed income space had not decreased following the financial crash.
The findings from authors Matteo Aquilina and Felix Suntheim, who work in the FCA chief economist’s department, come despite the watchdog itself having increased scrutiny of the area in recent years, amid concerns that regulatory changes had led banks to pull back from the market.
The amount held in corporate bonds by UK dealers fell from £400bn in mid-2008 to just £250bn at the end of 2014, the paper said.
But the authors noted there had been “no corresponding drop in liquidity in the UK’s £2.5tn corporate bond markets”, according to transaction data the FCA published today alongside the paper.
“In fact, aside from a relatively brief period immediately after the crisis, illiquidity has been decreasing to very low levels,” they added.
“In numerical terms, roundtrip costs – a reliable indicator of liquidity – had declined from a peak of around 0.5 per cent in 2009, to 0.1 per cent at the end of 2014.”
Similarly, neither surges in US treasury yields at the time of 2013’s “taper tantrum” nor the 2014 Treasury “flash crash” appeared to have made a “noticeable impact” on bond liquidity, according to the data.
The paper suggested banks “may have reacted to costlier capital with less proprietary trading but this has not, in turn, affected their market making activity in such a way as to impact liquidity”.
“The other, more speculative, possibility is that recent changes in technology and data analysis are today allowing dealers to manage their portfolios more efficiently, meaning they are able to provide similar levels of liquidity with smaller inventories,” it added.
The work noted, however, that it could be some time before there was a “definitive conclusion” on the subject, adding: “while liquidity in the past is a comfort, it is not a guarantee of its presence in the future.
“When everyone is rushing from a crowded room for the same exit doors, crushes ensue.”
