Much of the responsibility for market liquidity remains with issuers and purchasers of debt over banks, the Bank of England has said.
In a speech on October 27, Minouche Shafik, deputy governor for markets and banking, said market participants must adapt to a new framework where banks may not always be incentivised to provide liquidity.
Fixed income markets have come under severe criticism over the past 12 months on concerns about illiquidity, with regulations such as Basel III forcing banks to hold more capital, making them less likely to act as liquidity providers in times of market stress.
However, speaking at the AQR Asset Management Institute at London Business School, Ms Shafik said regulation could not solely be held responsible for the change in market structure, and ‘caveat emptor’ still applied to the purchases of debt.
Ms Shafik said the changing market structure meant participants should look at ways to create a substantial secondary market, and suggested investors should price liquidity appropriately, and manage it prudently.
“When making the decision to purchase an asset they should ensure their investment horizon is aligned with the inherent liquidity of that asset,” she said.
“They also need to understand that abundant market liquidity in normal times may not be indicative of the ease with which they can exit a position or effectively hedge it in times of stress.”
Ms Shafik said while it was “undeniable” regulation played a part in illiquidity, risk awareness, evolution and innovation were equally important.
She said banks were wary of extending balance sheets due to internal risk limits, brought in after over-exposure prior to 2008.
She said: “The response of regulators, banks and individuals to the financial crisis is recognition of the fact that – with the benefit of hindsight – the over-extension of banks’ balance sheets in the provision of liquidity before the crisis was ultimately unsustainable.”
Ms Shafik said banks using warehousing capabilities more efficiently and electronic trading platforms making banks’ market-making less necessary have also played a part.
While she said measures had been taken by the central bank to change and support the market structure, she claimed these would not be a panacea. Mifid II would also enhance market stability by moving trades onto centralised venues, she said.
“Liquidity provision under the previous structure was ultimately proven unreliable when it was needed most, and having a better capitalised, more resilient core of the financial system will improve the resilience of liquidity over the long run,” she added.