Secretariat of the International Organization of Securities Commissions (IOSCO)
Oquendo 12, 28006
MadridSpain
Email: consultation-2016-01@iosco.org

26 October 2016
Re: Public Comment on Examination of Liquidity of the Secondary
Corporate Bond Markets
Dear Sirs and Madams,
The Global Financial Markets Association (“GFMA”)i and the Institute of International Finance (“IIF”)ii(together, “the Associations”) welcome the opportunity to comment on the paper and consultation
issued in August 2016 by the International Organization of Securities Commissions (“IOSCO”)
entitled Examination of Liquidity of the Secondary Corporate Bond Markets (“the Paper”).
We would appreciate, and would be happy to arrange, a meeting with market participants to further
discuss your consideration of these views. Please do not hesitate to contact David Strongin, Executive
Director at GFMA (dstrongin@gfma.org); Pablo Portugal, Director at AFME
(Pablo.portugal@afme.eu); Brad Carr, Deputy Director at IIF (bcarr@iif.com) or Richard Gray, Senior
Policy Advisor at IIF (rgray@iif.com).

I.

Executive summary and main recommendations

We welcome and support IOSCO’s efforts to assess the current liquidity environment in corporatebond markets. Liquidity is a fundamental component to healthy and vibrant global capital markets
and the bond markets are an important source of financing for economic growth. Secondary markets
are vital to corporate issuers. They provide information on the cost of borrowing as the pricing of
new issues is guided by secondary markets. Bond markets also play a crucial role in monetary policy
and financial stability. Deep and highly liquid secondary markets support reliable price discovery
from a regulatory perspective, and therefore enhance the confidence supervisors can have in theveracity of crucial liquidity metrics of banks.
Robust market liquidity is therefore essential to efficient capital markets that can drive capitalformation, investor opportunity and funding needs. Given their crucial role in monetary policy,
1funding and financial stability, it is appropriate that regulators pay particular attention to theevolution of these markets.
We strongly support the establishment of a new IOSCO project intended to analyze the interaction
between transparency regimes and liquidity. This will be an important exercise given the current
liquidity environment and the many developments since IOSCO published its report on transparency
in corporate bond markets back in 2004. The Associations look forward to continuing to work withIOSCO as the liquidity environment and structural changes in corporate bond markets continue to beanalyzed.
In this submission we argue that there are sufficient early warning signals to suggest that regulationand other market factors are contributing to a reduction in certain aspects of secondary liquidity incorporate bond markets that is likely to be exacerbated by the unwinding of quantitative easing (QE)or another stressed market situation.
Although the evidence presented in IOSCO’s report may arguably show relatively limited impacts, we
argue that IOSCO’s analysis was based on incomplete information which can be subject to differinginterpretations. We also caution against downplaying the feedback from the majority of both buyside and sell-side respondents to the IOSCO survey who perceive market liquidity to have decreasedin the recent period.
We agree with the analysis that corporate bond markets are undergoing a period of transition as
regulation and technological developments drive structural changes; however, we caution against
the assumption that all adaptive behaviors will prove sustainable when monetary conditions are lessaccommodative. In particular we highlight the distortive effects of QE, low interest rates andunconventional monetary policy, as well as potential risks that may arise when more normal
conditions are re-established. Furthermore the efficacy of a new market structure and its
characteristics are unproven in stressed conditions.
We note IOSCO’s request for market participants to provide further data that would help refine its
analysis, including specific dealer inventory levels (gross and net), statistics concerning dealer
quoting behavior, data related to orders that investors tried to execute but could not do so for various
reasons, among others. Clearly some of these statistics go beyond transaction data that is reported
and are thus much more difficult to obtain in view of strong proprietary considerations andcommercial sensitivities among the various participants. The Associations will continue to explorewith their members the possibility of sharing with regulators statistics for use in an anonymized andaggregated form.
We would like to highlight our main recommendations discussed in this response.
In order to achieve a longer range view of possible future risks in corporate bond markets,and to develop a proactive and transparent early warning process, the Associations
recommend the establishment of a permanent joint working group of senior central bank andregulatory officials and representatives from investors, corporate issuers, bank trading desks
and trade associations. Such a forum can also facilitate a forward-looking dialogue involving
relevant market participants on the evolution of corporate bond markets, including a focus
on structural changes as a result of regulation and technological developments.

2In the European context, the European Commission has established a new expert group to
examine the functioning of corporate bond markets. We believe the analysis could be
replicated at the global level under the leadership of IOSCO and other bodies. The European
Commission’s expert group will be tasked with investigating a number of concrete areas:
o
o
o
o
o
o

Expectations of how corporate bond markets will perform, how they might evolve,
and how efficient and resilient they are;
What role – if any - market-making could and should play in corporate bond markets;
can technology replace market-making?
The importance of pre- and post-trade transparency regimes for price formation andwhat market infrastructure may be needed in the future;
Whether further standardization, greater electronic trading or microstructurereforms could counteract declines in liquidity;
Whether and how a larger role of open-ended mutual funds and retail investors could
affect corporate bond market liquidity; andThe implications of changes in the investor base for liquidity levels and overallmarket resilience.

Regulators should continue to pay close attention to the practical feedback and anecdotal
evidence provided by market participants as exclusive reliance on empirical data analysis
may not capture a number of behavioral changes in bond markets. Also markets can change
quickly, and active engagement with market participants would provide dynamic and timely
insights into changing conditions and trends, far more effectively than historical data
analysis.

Central banks should remain vigilant about the impact of their asset purchase policies onmarket liquidity and give consideration to the potential evolution of the market when these
programmes are unwound.



Regulators should consider areas where further research is needed. We emphasize theimportance of analyzing data on unexecuted orders and dropped trades, as well as continuing
to develop an understanding on optimal liquidity levels across markets.

Regulators must carefully assess the calibration of existing and forthcoming regulations,
including those referred to in section VI, particularly in light of existing signs of fragility incorporate bond liquidity. Policymakers should continue to consider the aggregate impact of
current regulation and weigh the incremental financial stability benefits of new rules against
the incremental costs of diminishing market liquidity to ensure regulation is notcounterproductive. We recommend a process of systematic, quantitative and qualitative
assessment of the financial regulation framework over the coming years, particularly
focusing on the interactions between prudential and markets regulations.

II. GFMA and IIF engagement in debates on secondary market
liquidity
The Associations and our members have been keenly focused on liquidity conditions and the manyfactors influencing changes in market structure and market participant behaviors in corporate bond3

markets. We have provided and continue to provide input into debates at national, regional andinternational levels on the state of liquidity in fixed income markets.
As part of this effort GFMA and IIF released in August 2015 a comprehensive new report undertakenby PwC on the state of global market liquidity (“the PwC study”)1, produced on behalf of both
Associations. We will refer to this GFMA/IIF report and its findings in sections of this response.

III. Measures affecting liquidity conditions
Given the significant extent and pace of post-crisis regulatory change, the unprecedented monetaryconditions, changing business models and related factors, it is indeed difficult to isolate individual
cause and effect relationships in assessing how the liquidity environment is changing. A range offactors can affect liquidity in bond markets, including the macroeconomic environment, monetary
policy, technology, changes in business models, structural changes, market risk appetite andregulation. The Associations acknowledge that it is challenging to form a complete view of liquidity
as several indicators seem to point in different directions with respect to whether the environmentis deteriorating or improving.
In the current environment, numerous factors are likely to be contributing to liquidity conditions.
The Associations consider there are at least four main factors currently driving global market
liquidity conditions2:

Stable global monetary conditions;
Increase in electronification and digitalisation in financial markets;
Growth in the size of financial markets; andPerformance in the banking sector.

A.

Stable monetary conditions

QE programmes and the global economic and monetary environment have been generally favorable
to market functioning, such that detecting risks and fragilities becomes more challenging.
Unconventional monetary policy (i.e. large scale asset purchases or QE in the Eurozone, US and UK)
is having distortive effects in financial markets.
As discussed in the PwC study3, there is evidence that QE has influenced market liquidity. The risk isthat as a result of QE, the liquidity risk premia may have been compressed to artificially low levels infinancial markets, which masks the impact of reduced market making capacity. Recent researchsuggests that since the ECB’s decision to buy corporate bonds, the eligible universe has tightened by
63bps to 84bps and the bonds which have been purchased have tightened by 58bps from 100bps to42bps4. While central banks may keep their holdings for a long period of time, when a slowdown of
QE is announced, even before a formal unwinding of QE programs, there is a risk that an investor sell1 PwC Global financial markets liquidity study, August 2015. The full report, including an executive summary, isavailable here: http://www.pwc.com/gx/en/financial-services/publications/financial-markets-liquiditystudy.jhtml
2 For a more detailed analysis please refer to the PwC Global financial markets liquidity study, August 2015
3 Ibid.
4 HSBC Global Research, Credit Telegram – CSPP An update on what the ECB has bought, August 20164

off would occur in relation to assets they consider to be mispriced or assets considered beyond theirrisk appetite in normal conditions.

B.
Increase in electronification and digitalization in financial
markets
The development of electronic trading is changing the structure of bond markets, traditionallycentered on market makers and primary dealers through voice-based and bilateral relations. Whileelectronification and a greater participation of non-bank intermediaries in bond markets cancontribute to reducing transaction costs, in addition to other advantages, they may also create anillusion of market depth as trading can vary widely between normal conditions and periods of highvolatility where liquidity can quickly deteriorate.

C.

Growth in the size of financial markets

The size of financial markets has seen significant growth in recent years. Debt issuance in Europe andthe US has increased as governments have funded fiscal deficits and corporates have taken advantageof the current low interest rate environment. These instruments are increasingly being held by
investors. While the outstanding volume has increased significantly, trading volume has not kept up.
It follows that turnover rates – the ratio of trading volume to debt outstanding – for corporate bonds
have declined, which is a sign of reduced liquidity.
Meanwhile, the growth in assets under management has also been accompanied by the rapid growthof exchange-traded funds (ETFs). The growth in the size of financial markets is likely to put furtherpressure on market liquidity if and when central banks start to unwind QE. So while central banks do
not currently require secondary market liquidity to unwind their QE programmes, other investors
do and this demand for liquidity is likely to be further exacerbated when central banks work to
unwind their positions.

D.

Performance in the banking sector

Major structural changes continue to take place in the banking sector. Another PwC study5
undertaken on behalf of the Association for Financial Markets in Europe (AFME) suggested thatbanks have exited businesses where they have low scale, particularly in equities and commodities
trading, and are exiting from regions and jurisdictions in order to concentrate on areas of key
strength and utility. Further, more stringent regulatory requirements are also leading banks towithdraw from products and entire markets. This is a particular concern in emerging market
economies, a fact highlighted in the Financial Stability Board’s recent Annual Report6.

5 PwC study Impact of bank structural reforms in Europe, November 2014
6 FSB Third FSB Annual Report, July 20165

Industry surveys have underscored the view that market makers’ willingness to hold large inventory
positions has decreased, particularly in less liquid instruments, with market makers reportedly
focusing on activities that require less capital and balance sheet capacity7.
In summary, the current global economic, monetary and financial market environment is generally
favorable to liquidity, such that detecting risks and fragilities becomes more challenging. In addition,
the changes in liquidity are taking place amid the backdrop of significant changes to market structure
and technology, growth in investable assets and continued weak financial performance in thebanking sector. In general these trends are increasing the demand for market liquidity, while
reducing banks’ market making activities to support the provision of market liquidity.
Consequently, the Associations are of the view that it is not yet possible to fully assess the extent towhich regulatory and structural changes may bring benefits or pose material risks to secondary
market liquidity. We nevertheless believe, as discussed below, that there are sufficient early warning
signals to warrant great care and consideration to any potential incremental impacts on liquidity.
Forces that serve to directly or indirectly diminish liquidity may exacerbate any underlying fragilities
which are likely being masked by monetary conditions or temporary changes in market participant
behavior.
Although the evidence presented in the IOSCO report may arguably show relatively limited impacts,
this analysis was based on incomplete information which can be subject to differing interpretations.
In addition, the current state of QE, low interest rates and unconventional monetary policy is likely
masking the true state of market liquidity. Regulators should therefore continue to monitor andexamine market data over time with a view to regularly assessing the evolution of the liquidity
environment and challenging and corroborating the conclusions of various assessments.
Regulators should focus their analysis on potential impacts after the full effects of existing andcontemplated regulatory changes play out in more normal interest rate conditions. Potential effects
include higher direct transaction costs through wider bid-ask spreads, as well as indirect costs arisingfrom bigger price movements when there is buying or selling pressure from all but the smallest
transactions and from the indirect effects of greater overall volatility. Less stable markets, combinedwith higher transaction costs, could push up liquidity premiums demanded by investors.
It is through this lens that we have called for and continue to call for greater appreciation of andconsideration to the link between regulation and market liquidity so that future regulations strikethe right balance between promoting stability and maintaining financial markets liquidity.

IV.

Comments on IOSCO’s conclusions

We note that IOSCO’s report examined a range of different liquidity metrics in aggregate, undertook
surveys with industry and regulators and a literature review to develop an informed picture ofcurrent secondary corporate bond market liquidity. IOSCO notes that while some of the relevant
metrics (turnover ratio, dealer inventories, and block trade size) might indicate potential signs oflower liquidity, most metrics reviewed show mixed evidence of changes in liquidity (bifurcation of
trading average trade size, and average number of counterparties or market makers) or someevidence of improving liquidity (trading volume, bid-ask spreads, and price-impact measures). Based
7 BIS paper Market-making and proprietary trading: industry trends, drivers and policy implications, November

2014

6

on the totality of information collected and analyzed, IOSCO did not find substantial evidence
showing liquidity has deteriorated markedly from historic norms for non-crisis periods. IOSCO also
notes that there is no reliable evidence that regulatory reforms have caused a substantial decline in
the liquidity of the market, although regulators continue to monitor closely the impact of regulatory
reforms.

A.

General observations

In contrast to the final conclusion in IOSCO’s analysis, we note that the majority of both buy-side andsell-side respondents to the IOSCO survey perceive market liquidity to have decreased, with thisfeedback being based on experience rather than data analysis. The feedback is consistent with otherrecent regulator reports8 as well as recent surveys of participants with experience in the market ona daily basis as investors and risk managers9,10, 11. While IOSCO acknowledges this feedback frommarket participants, we caution against it being downplayed.
Liquidity is a simultaneously abstract and quantifiable concept. Liquidity can be defined as the ability
to execute an order at the given price, with as little market impact as possible. The features that tend
to be associated with liquid markets include low transaction costs, immediacy in execution, and theability to execute large transactions with limited price impact.
While details about trades can be quantified and tracked over time, participants may have differing
views about the secondary market liquidity environment at a given point, depending on their market
activities and strategies. For this reason we believe that liquidity assessments made solely on thebasis of observable trade data have limitations and, when considered in isolation, fall short ofproviding a complete view of the market environment.
By looking exclusively at executed trades, IOSCO’s analysis does not seek to capture or factor in an
examination of transactions or strategies which could not get pursued or concluded due to liquidity
conditions. We believe that a more complete assessment of the state of liquidity should factor in such
dynamics and participant behaviors not necessarily observed in the data sources. Many asset owners

8 By way of example, in its Financial Stability Report of July 2016, the Bank of England’s Financial Policy

Committee notes that “over the past year, government and corporate bond markets, including in the United
Kingdom, have shown signs of reduced liquidity, and activity in repo markets has fallen materially.” The reportnotes that these changes “probably, in part, reflect post-crisis regulations as firms adjust their risk management
and business models.”
9 See ICMA paper Remaking the corporate bond market, July 2016, pps. 19-20
10 ESRB Market liquidity and market-making, October 2016. According to the ESRB survey, Market liquidity isperceived to have decreased steadily and to have been more frequently disrupted in recent times. Survey
participants more frequently observed temporary, event-driven phases of illiquidity, such as during the Greek
referendum, or unexpected events, such as during the US Treasury flash crash in 2014.
11CFA Institute Survey Report on Secondary Corporate Bond Market Liquidity, September 2016. Respondents
from the AMER and EMEA regions report that over the last five years they have observed: (1) a decrease in theliquidity of high‐yielding and investment‐grade corporate bonds and no change in the liquidity of government
bonds; (2) a decrease in the number of active dealers making markets; (3) an increase in the time taken to
execute trades and a lower proportion of bonds being
actively traded; (4) a higher proportion of unfilled orders.

7have unrelated objectives and constraints that drive their behavior in disparate ways, suggesting thatmarket participants are unlikely to react to changes in market conditions in the same way12.
Post-trade data can, for example, fall short of reflecting behavioral changes such as participants
deciding to reduce trade sizes or not to execute an order. Post-trade data may give the impression ofliquidity by recording small trades, but fail to capture unexecuted trades in larger sizes or decisions
to trade in small sizes as liquidity was not available in larger sizes. Recent surveys of market
participants suggest that the execution of block trades has declined in recent years13 and that there
is a higher proportion of unfilled orders14. In other surveys, market participants also report that tradinglarge amounts of corporate bonds has become more difficult15.
By way of example the average trade size in US Treasuries and European corporate bonds has
decreased significantly since 2010. Declines in block-trades in US corporate bonds from pre-crisis
levels indicate a shift in trading patterns, with liquidity now associated with smaller trade sizes. This
may reflect the reality that as a result of the price impact of large transactions, dealers may be forced
to break up big transactions into multiple smaller transactions16. Such changes are important as they
can offer insight into potential participant needs and behaviors in period of stress or macroeconomicchange. It is also possible that some trades are no longer taking place, or happen later because of
reduced liquidity.
An important data source concerns unexecuted orders and “dropped trades” which occur when one
counterparty tries to hit or lift a posted price but the price is not fulfilled by the counterparty and thetrade is not executed. These metrics can offer insights on market behaviors. The Associations arewilling to work with their members and the relevant trading platforms to help provide data in asuitable anonymized format.
Participants can also have differing views about the market environment which may not be captured
in an empirical data analysis. For example, recent analysis by Greenwich Associates based on 58
fixed-income respondents in 2014 and 51 in 2015 suggests diverging views from participants on the
difficulty of trading corporate bonds according to trade size17. We have included below a figure fromGreenwich Associates’ 2015 Trading Desk Optimization Study to illustrate the diversity of views.

12 An analysis of this can be found in Blackrock Addressing market liquidity – A broader perspective on today’sbond markets, October 2016
13 CGFS paper Market-making and proprietary trading: industry trends, drivers and policy implications,November 2014
14 CFA Institute Survey Report on Secondary Corporate Bond Market Liquidity, September 2016.
15 Fender, I. and Lewrick, U. paper Shifting tides – market liquidity and market-making in fixed income
instruments, Bank of International Settlements, March 201516 See Oliver Wyman paper Interaction, coherence and overall calibration of post crisis Basel reforms, August
2016
17 https://www.greenwich.com/fixed-income-fx-cmds/understanding-us-fixed-income-market

8Greenwich Associates recently examined these differing views of corporate bond market liquidity in
the Q1 2016 report In Search of New Corporate Bond Liquidity18. While many institutional investors
felt that executing corporate bond trades over $5 million had become easier over the past year, others
still saw these trades as difficult to complete. Such surveys of market participants can offer important
insight into the state of market liquidity to complement an analysis of quantitative measures such asbid-ask spreads and market volumes.
Metrics have limitations in providing a deep understanding of the underlying market participant
behaviors, perceptions and decision making. A variety of metrics create mixed pictures and can beinterpreted in different ways. Aggregating different metrics that consider different facets of liquidity
to present a generalized view of the overall liquidity could mask underlying liquidity challenges. We
therefore recommend that metrics be interpreted individually to identify specific areas whereliquidity may have been impaired, while taking into account structural changes that could influenceinterpretation. For example, although the recent compression of bid-ask spreads has been used as
evidence of benign liquidity environment, it is also the result of other changes in market structure
and behavior of market participants that in fact point to lower capacity for market making by market
participants.
For example, a study by ICMA in 201419 notes that intermediaries have responded to regulatory
requirements by shifting from a principal to agency trading business model, which requires holding
smaller quantities of bonds in inventory. Firms have therefore been able to reduce their inventory
costs which partly explains why spreads have not widened significantly. These reservations aresupported by the Joint Staff Report into the US Treasury market on 15 October 201420 which notesthat “average bid-ask spreads and market depth, though often indicative of general market
conditions, may need to be complemented by other measures in light of these [structural] challenges
to obtain a more meaningful picture of the state of market liquidity in the current market
structure.” For this reason, we also reiterate the importance of analyzing quantitative data inconjunction with the qualitative feedback from market practitioners.
We also note that more research is needed to form a better understanding of optimal liquidity levels
across different markets. If there was, arguably, a surplus of liquidity in the run up to the financial
crisis, what is an appropriate benchmark for the various classes of corporate bonds? Such analysis
18 http://delphx.com/files/1414/5952/1564/GA_-_Corporate_Bond_Liquidity_-_April_2016.pdf
19 ICMA paper The current state and future evolution of the European investment grade corporate bond secondary

market: perspectives from the market, November 2014.
20 Joint Staff Report The U.S. Treasury Market on October 15 2014, July 20159

would help understand whether the decrease in liquidity observed in certain market segments
corresponds to a desired post-crisis adjustment, or whether it suggests a deterioration in conditions
with negative consequences for market participants.
A recent analysis by the Federal Reserve Bank of New York discusses several directions for future
research. According to the analysis: “Firstly there is a lack of data across markets and within markets;
secondly there are deﬁciencies in methodology in the face of incomplete data; and thirdly there islittle attention to the endogenous response of market participants to an already changing liquidity
environment. Each of these are promising directions of future research in measuring liquidity”. It isalso argued that many traditional liquidity metrics, when computed on selective subsets of data or
ignoring endogeneity, are not immune to these measurement challenges and may therefore paint an
incomplete picture of current liquidity conditions21.
Market liquidity can also become severely impaired due to a turn in cyclical factors. These factors,
including monetary policy conditions, are currently creating benign market liquidity conditions
which can create the illusion of resilient market liquidity. However, these can turn quickly, resulting
in rapidly deteriorating liquidity across asset classes. This calls for a better understanding of how
these metrics are likely to respond to a stressed environment.
We would like to make the following general observations of IOSCO’s analysis, referring to the PwC
2015 study sponsored by the Associations.
Data sources

Data sources used for IOSCO’s study and the PwC study differed, which may have led todiffering interpretations on the liquidity environment. As noted by IOSCO, one of the primarychallenges it faced during this assessment was a lack of useful data in most jurisdictions on
the trading of corporate bonds in the secondary market in each country22.



In addition, as discussed previously, there was no consideration of failed or withdrawn tradesthat would provide at least as useful a measure of true liquidity as a study of the trades thatwere executed. As previously noted, data on unexecuted orders and “dropped trades” canoffer valuable insights into participant behaviors.

In relation to Asian markets, we note that IOSCO’s study did not cover China and utilized
Asian market information that may not have appropriately captured the majority of themarket.

Regional differences

We also note that IOSCO’s analysis shows clear differences across regions – for example
between the US, Europe and emerging markets – which have not been explored in the report.
In general, we have the impression that IOSCO’s analysis does not sufficiently take into

21 Federal Reserve Bank of New York Market Liquidity After the Financial Crisis, October 2016. The paper

concludes that for corporate bonds, bid-ask spreads and price impact have returned to pre-crisis levels, while
volume and issuance are at record highs. The paper’s analysis suggests that market liquidity overall isfavorable.

10

consideration important regional differences in terms of corporate bond market structure
and reliability and comparability of data.
Regional differences can be important. For example, recent analysis suggests that liquidity insovereign and corporate bonds is generally lower in Europe than in the US (e.g. higher
transaction costs). Banks also play a more important role in determining market liquidity inthe Euro area than the US. In addition, it is felt that the ECB’s unconventional monetary policy
programmes are currently substituting for market activity in the European context23.



Recent surveys of market participants show clear differences in perceptions of liquidity
across regions. For example, APAC region respondents to a recent survey by the CFA Institutereport that over the last five years they have observed 24:oooono change in the liquidity of high‐yielding corporate bonds but an improvement in
the liquidity of investment‐grade corporate and government bonds;
an increase in the number of active dealers making markets;
no change in the time taken to execute trades and a higher proportion of bonds being
actively traded; andno change in the proportion of unfilled orders.

This feedback in relation to the APAC region is markedly different from perceptions regarding
the AMER and EMEA regions, as noted under footnote 11 above.


We note IOSCO’s finding that trading volumes in emerging markets have been volatile since
the crisis and that the absence of a longer data series makes it difficult to draw conclusions
about trading volume trends in the emerging markets.

Number and nature of counterparties

It is important to note that liquidity provision can be linked to the nature of counterparties.
As broker-dealers become more selective in their choice of counterparties and balance sheet
allocation, IOSCO could in the future explore whether large and small asset managers areexperiencing differences in the levels and pricing of liquidity.



IOSCO notes that there is an increase in the number of market participants, based on an
increase in the number of counterparties per dealer based on TRACE data. We note that thisis not necessarily positive: it could also be indicative of greater market fragmentation and theneed to break up trades into smaller sizes and spread it over a large number of counterparties
because no single counterparty can provide the depth required to absorb the trade in one go.

Immediacy

Immediacy typically refers to the time it takes to complete a transaction. It is, we believe, a
key factor in any liquidity assessment – arguably more important than information on
executed trades. As previously noted, we encourage IOSCO and other regulators to examine

23 Goldman Sachs paper Assessing market functioning through liquidity developments, April 2015

24 CFA Institute Survey Report on Secondary Corporate Bond Market Liquidity, September 201611

data on unexecuted orders and dropped trades. We are aware of the challenges in obtaining
such data across jurisdictions and stand ready to work with our members and the relevant
trading platforms to help in this area of analysis.
Signs of bifurcation

Research by the Committee on the Global Financial System25 (CGFS) and Fender and
Lewrick26 found liquidity has tightened in certain bond markets, with spreads widening inhigh yield and emerging market corporate debt. Their research also suggests that liquidity is
increasingly concentrating in the most liquid instruments and falling in less liquid assets.

A subsequent paper published in 2016 by the CGFS27 found that liquidity bifurcation
continues particularly for off-the-run sovereign bonds and corporate bonds. We note IOSCO’s
statement that some industry participants, particularly those on the buy-side, have reported
that a “bifurcation” is taking place in secondary markets in corporate bonds. As IOSCO notes,
it is possible that dealers are less willing or unwilling to make markets in relatively illiquid
high-yield bonds and are instead shifting toward an agency model in these bonds.



In preparing this submission, our dealer-bank members noted that trading practices andprovision of quotes to clients have adjusted to the impact of the ECB bond purchase programs.
Dealers report that for QE-eligible instruments they are able to quickly provide quotes andnarrow spreads to their clients, whereas pricing and immediacy may be noticeably different
for non QE-eligible bonds.

Research suggests that the growing supply of new issues has concentrated trading in the mostrecently issued securities. FINRA found that the average annual percentage of bonds among
the most active 1,000 that were issued within the last 90 days between 2003 and 2007
remained below 20%, but since 2011 has averaged 45%. Similarly, there has been a marked
decline in the trading volume among active issues after they have been in the market for 90
days. FINRA found that after their first 90 days in the secondary market, par trading volume
fell by 38% in 2015, 250% faster than occurred in 200728.

Commentators have also argued that there is evidence of an increase in bifurcation in day-today trading conditions, visible in daily volatility levels across markets. Rather than there
being a steady stream of moderately volatile days (and liquidity conditions), volatility seems
to be becoming more clustered than it used to be: there are many days with tight ranges andgood liquidity, and then occasional days of extreme intraday volatility and reportedly poor
liquidity – even though volumes on such days can actually remain quite high29.

25 CGFS paper Market-making and proprietary trading: industry trends, drivers and policy implications,November 2014
26 Fender, I. and Lewrick, U. paper Shifting tides – market liquidity and market-making in fixed income
instruments, Bank of International Settlements, 2015
27 CGFS Papers Fixed income market liquidity, No 55, January 201628 Mizrach, B, paper, Analysis of Corporate Bond Liquidity, FINRA, December 2015
29 Citi The liquidity paradox, May 201412

Volatility

We notice that measures of volatility appear to not have been significantly taken into accountin IOSCO’s report. This is important as liquidity provision from market makers is precisely
needed in times of volatility. We would point IOSCO to the following recent analysis
illustrating how declining dealer inventories may be linked to higher volatility and lower
liquidity:oThe academic paper Capital Commitment and Illiquidity in Corporate Bonds (July
2016) studies US corporate bond markets from 2003 to 2014 and provides data
indicating that liquidity has been negatively impacted by unintended consequencesof post-crisis regulations focused on banking30. The evidence supports that theseoutcomes reflect unintended consequences of post-crisis regulations focused onbanking.

o

The Bank of England’s December 2015 Financial Stability Report finds that market
makers in US corporate bonds have become less willing to absorb demand shocks andthat the volatility of spreads has increased as a consequence31.

o

As noted in PwC’s 2015 report, there is evidence that episodes of market correction
and volatility are now rising, after falling considerably since the global financial crisis.
Volatility in bond markets in 2015 was around 40% higher than in 2014, finds PwC.
Whereas current market volatility is not as high as the extreme levels of volatility
witnessed during the global financial crisis, volatility is arguably above historicallevels during benign economic conditions.

oSovereign bonds, generally considered a more liquid asset class compared tocorporate bonds, have also experienced episodes of volatility such as the 15 October
US Treasury “flash crash”, which caused a temporary plunge and subsequent
recovery in US Treasury yields32.

Single-name CDS market


IOSCO’s analysis has not focused much attention on the importance of the single-name CDS
market, which is important in allowing market makers in corporate bonds to manage theirrisk efficiently as well as providing a reference point for pricing bonds. Industry surveys33
have highlighted that liquidity in the single-name CDS market has been in decline as the
combined effects of regulations – including the Leverage Ratio, capital charge for credit
valuation adjustment (CVA), and other expected regimes – have affected market makers of
CDS.

30 Capital Commitment and Illiquidity in Corporate Bonds, by Hendrik Bessembinder, W.P. Carey School ofBusiness, Arizona State University, Stacey Jacobsen, Cox School of Business, Southern Methodist University,
William Maxwell, Cox School of Business, Southern Methodist University, Kumar Venkataraman, Cox School ofBusiness, Southern Methodist University, July 2016.
31 See Bank of England Financial Stability Report, December 2015
32 US Department of Treasury, the Federal Reserve, SEC and CFTC Joint Staff Report: The U.S. Treasury Market
on October 15, 2014, 2015
33 See ICMA paper Remaking the corporate bond market, July 2016.

13

Meanwhile, a recent study published by ISDA notes that in recent years the single-name CDS
market shifted from stagnating growth to an actual contraction and has shrunk substantially,
experiencing a contraction of 61% between June 2011 and June 201534. As noted in the ISDA
study, the empirical evidence overwhelmingly supports the conclusion that single-name
CDSs lead corporate bonds in price discovery given the illiquidity in cash corporate bonds
relative to single-name CDSs.

Central bank and monetary policyWe note that it was not part of the scope of IOSCO’s report to examine how QE and low
interest rates may have impacted liquidity in the post-crisis environment, although IOSCO
acknowledges these are relevant factors to consider. We reiterate that any analysis of thecurrent liquidity environment needs to take into consideration central bank purchaseprogrammes which have the effect of reducing free-float35 and therefore carry a potential togenerate significant market distortions. For example, purchase programmes have been
expanding with the European Central Bank now purchasing government bonds, coveredbonds and corporate bonds. The last eight years are unprecedented in terms of the amountof fixed income instruments purchased by central banks, with approximately $7 trillion ofbonds purchased and currently held on central bank balance sheets. It is expected that atsome point in the future these programmes will begin to unwind.

Repo market


While IOSCO notes suggestions that dealer-banks’ appetite to intermediate repo markets haschanged recently, it notes that none of the respondents to the IOSCO survey provided
quantitative evidence supporting these assertions. We refer to the following papers which
IOSCO may wish to review:o

ICMA paper Perspectives from the eye of the storm: the current state and future
evolution of the European repo market’, November 2015 – it is noted that the cost of
repo has increased and is likely to go up even further with the full implementation of
the Liquidity Coverage Ratio, Net Stable Funding Ratio and Leverage Ratio.

o

See Oliver Wyman paper Interaction, coherence and overall calibration of post crisis
Basel reforms, August 2016 – it is noted that dealers are allocating less balance sheet
capacity to repo activity; it is also noted that repo balances of European banks havedeclined by around 40% since 2011 and those of US banks have declined by around12%.

oBank of England’s Financial Stability Report, July 2016 – it is noted that activity in UK
gilt repo and US repo markets has contracted significantly since the end of 2013, byaround 25% and 10% respectively. The report states that “The most marked changes
in market conditions have been in the securities financing markets, specifically, those

34 ISDA paper Single-name Credit Default Swaps – A review of the Empirical Academic Literature, September

2016.
35 In a sense when a central bank buys bonds, they withdraw them from the market. Free float indicates thepercentage of bonds that remain to be actively traded. In theory, the fewer actively traded bonds, or the lower
the free-float, the wider their price fluctuations.

14

for repurchase agreements, or ‘repo’. The FPC judges that these developments are of
sufficient importance to financial stability and market functioning to warrant further
domestic and international assessment of their causes and consequences.”The cost of repo funding is a crucial consideration for market makers as they will often
borrow the securities via the repo market to provide liquidity to their clients. We agree withIOSCO’s view that a deterioration of liquidity in repo markets, or an increase in costs
associated with using repo markets, could conceivably have a negative knock-on effect onliquidity in secondary corporate bond markets.

B.

Feedback and comparison of specific metrics

In this section we offer a more specific examination of the liquidity metrics considered by IOSCO.
While the same data sources and estimation approach for some indicators have been consistentacross a number of studies, there are others where these have differed, leading to different results
and interpretations of the data. This section sets out these examples, particularly where they indicate
liquidity challenges in corporate bond markets.
Turnover ratio
The turnover ratio can be calculated in a number of ways and for individual instruments or a market
as a whole and for different trading periods. Whereas IOSCO concluded the turnover ratios it
analyzed were broadly flat, the PwC study showed declining turnover across major global corporatebond markets (Figure 1). This is supported by more recent data from MarketAxess on the US
corporate bond market (Figure 2).
An examination of more recent data on Asian corporate bond markets (Figure 3) from the AsianDevelopment Bank also shows that corporate bond turnover ratios have also declined for a sampleof Asian emerging markets.
Other studies have also observed declines in turnover ratios in different asset classes and markets36.
Based on the experience of the recent crisis, turnover ratio could be expected to drop further in theevent of a future stress environment.

36 See Oliver Wyman paper Interaction, coherence and overall calibration of post crisis Basel reforms, August

2016.

15

Figure 1: Corporate bonds turnover ratio (average daily volume / outstanding volumes)
0.40%
0.35%
0.30%
0.25%
0.20%
0.15%
0.10%
0.05%
0.00%
2010

2011

Asia

2012
Europe

2013

US

2014

Source: Asian Development Bank, Trax, SIFMA, PwC analysis

Figure 2: US corporate bonds turnover ratio (average monthly volumes / outstanding volumes)
9.0%
8.0%
7.0%
6.0%
5.0%
4.0%
2008

2009

2010

2011

2012

2013

2014

2015

2016

Source: Trax

Figure 3: Corporate bond turnover ratios for selected Asian emerging economies
25%
21%

22%

22%

20%

20%

17%

17%

2014

2015

15%
10%
5%
0%
2010

2011

2012

2013

Source: Asian Development Bank. Note this is based on data from Japan, Korea, Thailand, Malaysia

16

Trade sizes
IOSCO suggests that PwC analysis of average trade sizes (Fig 16 in IOSCO report) could have been
affected by exchange rate movements. However, even after correcting for exchange rate effects, thedata nevertheless exhibits a downward trend between 2010 and 2015 (Figure 4).
Figure 4: European corporate bonds - Average trade size (Based on PwC data used in GFMA report)
800

EUR thousands

700
600
500
400
300
200
100
0
2010

2011

2012

2013

2014

2015

Source: Trax data. Note 2015 data only for January to March

More recent data from Trax (Figure 5) on the European corporate bond market suggests that tradesizes have also declined between 2014 and 2016 – average transaction size declined by 16% between
2014 Q2 and 2016 Q2.
Figure 5: European corporate bonds - Average trade size (Trax Fixed Income update)

US$ thousands

1000
800
600
400
200
0
2014 Q1 2014 Q2 2014 Q3 2014 Q4 2015 Q1 2015 Q2 2015 Q3 2015 Q4 2016 Q1 2016 Q2
Source: Trax

Again this demonstrates the need to agree on a basis of calculation of trade size data so that the wholefinancial community is drawing conclusions from an agreed definitional analysis.

17

Meanwhile, in a recent analysis the ESRB37 finds that there has been a significant decline in median38
trade size for corporate bonds issued by both non-financial and financial corporations while trading
volumes decreased only slightly. The ESRB’s analysis of changes in market makers’ median tradesizes, volumes and inventories suggest that liquidity resilience may have decreased in bothgovernment bond and corporate bond markets.
In a recent analysis, the Federal Reserve Bank of New York noted that average trade size declined
sharply during the crisis and never recovered; it is noted that some market commentators see thistrend as evidence that investors find it more difficult to execute large trades and so are splittingorders into smaller trades to lessen their price impact39 40.
Price impact measure
Price impact measures are potentially a very important indicator of market liquidity conditions, as
they provide more information on the cost of illiquidity. There have been a number of instanceswhere reports (provided by both regulators and industry commentators) have calculated andpresented price impact measures on a different definitional basis and/or with very different results.
For example, PwC used the Amihud measure of price impact, which captures the ratio of the absolutedaily returns to its trading volume, averaged over each month. This analysis was performed using
data on trading volumes for a sample of European corporate bonds from Trax. The study shows thatthe price impact measure is sensitive to market conditions, which results in highly volatile trends(e.g. manifesting in peaks and troughs). It should also be noted that it showed an increase in the
Amihud measure of price impact at the beginning of 2015. In contrast, IOSCO and the FCA havepresented price impact measures which have reached virtually all-time lows in 2015, which is also
markedly different to the anecdotal views of market participants.
It is clear that different data sources and estimation approaches can result in different conclusions
on liquidity trends. The above assessment therefore underscores the need to also consider
alternative sources of market data to ensure that a representative view of market liquidity is
captured.

V.

Current market environment
A.

Signs of fragility

We continue to believe that there are sufficient early warning signals to suggest that regulation andother market factors are contributing to a reduction in certain aspects of secondary market liquiditythat is likely to be exacerbated by the unwinding of QE or another stressed market situation. Indeed
the FSB highlighted similar concerns in its recent Annual Report stating that: “There is limited
evidence of a broad deterioration in market liquidity, although there is some evidence of less depth
in certain sovereign and corporate debt markets41.”

37 ESRB Market liquidity and market-making, October 2016.
38 The median is the median of average trade sizes reported by the market-makers.
39 Federal Reserve Bank of New York Market Liquidity After the Financial Crisis, October 2016.
40 See also the analysis by Greenwich Associates referenced under footnotes 17 and 18 above.

41 FSB Third FSB Annual Report, July 2016.

18

Policymakers should continue to consider the aggregate impact of current regulation and weigh theincremental financial stability benefits of new rules against the incremental costs of diminishingmarket liquidity to ensure regulation is not counterproductive. We note as a result of recent
observations the FSB has committed to “…more active monitoring and analysis, especially of changes
in market depth and funding liquidity conditions”42. We fully support this work, with a particular focus
on the impacts of progressive implementation of regulatory reforms as discussed further below.
Regulator and industry-sponsored studies inevitably rely on specific data samples and a snapshot ofmarket conditions to assess market conditions at a given point. We believe that secondary corporatebond market liquidity should be a matter of continual assessment by policymakers as the regulatory
reform programme is gradually implemented. In order to achieve a longer range view of possible
future risks, and to develop a proactive and transparent early warning process, the Associations
recommend the establishment of a permanent joint working group of senior central bank andregulatory officials and representatives from investors, corporate issuers and bank trading desks.
We recommend that regulators continue to pay close attention to the practical feedback andanecdotal evidence provided by market participants. While the totality of empirical information may
continue to show a mixed picture, regulators should not ignore recent signs that point to greaterfragility of market liquidity in corporate bond markets. For example:

As noted above, PwC’s 2015 analysis finds that European corporate bond trading volumes
have declined by up to 45% between 2010 and 2015. Evidence suggests that block trades are
becoming more difficult to execute without affecting prices. Banks’ holdings of trading assets
have decreased by more than 40% between 2008 and 2015, and dealer inventories ofcorporate bonds in the US have declined by almost 60% over the same period, finds PwC’s
report. This has accompanied a decline in turnover ratios in corporate bond markets, wheretrading volumes have failed to keep pace with the increase in issuance.



The academic paper Capital Commitment and Illiquidity in Corporate Bonds (July 2016)
studies US corporate bond markets from 2003 to 2014 and observes that despite a decreasein trade execution costs post-crisis, alternative measures, including intraday and overnight
dealer capital commitment, dealer participation as principals, turnover, the frequency ofblock trades, and interdealer trading, have not returned to pre-crisis levels and in many cases
have worsened. The reduction in dealers’ commitment to bond market making in recent years
is attributable to bank-affiliated dealers, while non-bank dealers have increased their
participation. The evidence in the study supports the view that these outcomes reflect
unintended consequences of post-crisis regulations focused on banking43.

In the EU, ESMA’s Report on Trends, Risks and Vulnerabilities44 (No. 2, 2016) observes nosystematic trends in liquidity levels in EU corporate bond markets between March 2014 andMarch 2016, but finds episodes of decreasing market liquidity when wider market conditions
deteriorate.

42 Ibid.

43 Capital Commitment and Illiquidity in Corporate Bonds, by Hendrik Bessembinder, W.P. Carey School ofBusiness, Arizona State University, Stacey Jacobsen, Cox School of Business, Southern Methodist University,
William Maxwell, Cox School of Business, Southern Methodist University, Kumar Venkataraman, Cox School ofBusiness, Southern Methodist University, July 201644 ESMA’s Report Trends, Risks and Vulnerabilities, No. 2, 201619

In their paper Fixed Income Market Liquidity (January 2016) the CGFS found evidence ofgreater fragility in liquidity conditions. The paper highlights reduced trade size and greater
reluctance of dealers to undertake market making activities, pinpointing regulatory change
as a key contributor. The CGFS also poses the question that the liquidity support mechanismsof central banks may be at the cost of greater market fragility45.

Such fragilities signal the need for careful consideration of incremental regulatory impacts. It is
widely recognised that there are substantial benefits to the appropriate implementation of recent
reforms in response to the crisis. Equally, there are increasing concerns regarding the interaction
between various reforms and their cumulative economic effect on the liquidity environment. Thereis clear need for carrying out a process of systematic, quantitative and qualitative assessment of thefinancial regulation framework over the coming years. This should include not only a holistic
assessment of G20 reforms to bank prudential regulations, but also their interaction with market
regulations and broader economic and monetary conditions.
B.

Structural changesi.

Technology and innovation

As acknowledged by IOSCO, there are also clear signs that market structure and participants’behavior is adapting to the evolving environment. The growth of ETFs provide investors with a moretradeable instrument for investment, in the absence of directly investing in the underlying asset,
which may not be as liquid. Meanwhile, a more widespread adoption of electronic trading could
further reduce transaction costs for market participants by providing additional platforms to match
buyers and sellers. Such platforms will, in some cases, help reduce the time required to locate buyers
and sellers and improve the process of price discovery.
While electronic trading platforms can bring many positive effects, they are unlikely to fully replaceliquidity provision by dealers, in particular the ability to bear proprietary risk and provide
immediacy. Electronic trading can help efficiency but it does not in itself create liquidity. It is alsoquestionable whether a full automation of credit markets is realistic or desirable. These markets are
distinct from equities, commodities, foreign exchange and sovereign bond markets. The high degreeof complexity and heterogeneity – companies will often issue many different types of bonds, withvarying interest rates and maturities – has so far made the market maker principal trading model
indispensable in allowing investors to trade instruments and restructure their debt portfolios.
When a market maker absorbs an investor’s supply of a given instrument, it will use its distribution
network to find the other side of the trade, or if unable to locate a buyer, may take the debt into
inventory pending the location of a willing buyer. For these reasons, dealer-client relationships andvoice brokerage remain key aspects in corporate bond markets. While technology has an importantrole to play, it is unlikely to supplant dealer-client relationships and non-electronic modes of tradingin the foreseeable future.
There are also suggestions that electronic trading may be boosting market volumes but adding little
depth for those who need to trade in size. When markets become more volatile, it is observed thatelectronic trading operators tend to withdraw – or, at best, reduce the size in which they are willing
45 CGFS Papers Fixed income market liquidity, No 55, 201620

to trade46. For example, an IMF analysis concluded that a reduction in the depth of order books seems
to have led the “flash rally” in US Treasuries on 15 October 201447.
ii. Potential risks
While we agree with IOSCO’s sentiment that the liquidity environment is dynamic and thatparticipants have demonstrated an ability to change and adapt, we caution against the assumptionthat all adaptive behaviors in corporate bond markets will prove sustainable when monetaryconditions are less accommodative. As noted in the PwC study, the effect of QE on portfolio
rebalancing and the liquidity risk premia are likely to reverse following the withdrawal of QE, which
could expose the structural reduction in liquidity in capital markets. PwC’s analysis notes thatmonetary policy normalization and the reversal of QE in the US or EU could result in persistently
higher levels of liquidity risk premia as the market adjusts to an environment of higher interest rates,
which could be accompanied by periods of heightened illiquidity and market volatility.
An increase in costs for underlying investors due to illiquidity will impact their returns. We
recommend that central banks remain vigilant about the impact of their asset purchase policies onmarket liquidity and give consideration to the potential evolution of the market when these
programmes are unwound.
Another important area of attention concerns the decline in the CDS and repo markets, which risk
reducing participants’ ability to hedge and/or finance the purchases of corporate bonds. These
markets should be carefully monitored and the impact of regulation on hedging capacity should be
evaluated.
In the EU context, ESMA’s recent assessment of risks and vulnerabilities finds that market and credit
risks are very high – the highest level – while liquidity and contagion risk remain high. ESMA notesthat the risk outlook has deteriorated following the result of the UK referendum on EU membership.
Market, liquidity and contagion risks may increase going forward, as political and event risks haveintensified, and the macroeconomic environment may weaken. According to the report, thedeteriorating liquidity risk outlook reflects increased fund outflows following the referendum,
leading, among other impacts, to the suspension of redemptions in a number of open-ended funds
holding UK commercial property48.
As recently noted by the ESRB, “liquidity illusion” remains a risk to financial stability as theexperience from the financial crisis has shown that, in normal times, liquidity conditions may beperceived to be ample, but a sudden lack of liquidity can occur during times of stress. Evidence of
event-driven phases of illiquidity may be cause for concern. Respondents to the recent ESRB survey
more frequently observed temporary, event-driven phases of illiquidity, such as during the Greek
referendum, or unexpected events, such as during the US Treasury flash crash in 2014. According tomost respondents, lower market liquidity has its origin in a reduction in the number of market
participants, investors in general and market-makers in particular, as well as capital and balance
sheet constraints potentially as a result of regulation49.
46 Citi research The liquidity paradox – The more liquidity central banks add, the less there is in markets, May

2015
47 IMF Financial Stability Report, The October 15 Flash Rally in US Treasuries, April 2015, see Figure 1.19
48 ESMA’s Report Trends, Risks and Vulnerabilities, No. 2, 201649 ESRB Market liquidity and market-making, October 201621

Recent research also suggests that market participants are concerned about the increasing frequency
of “flash crashes” that occur without obvious causes50. For example, there have been a number of
events with erratic price movement outside of normal ranges expected for market movements in
response to external events:


The flash crash in US treasuries – when there was a steep drop of 37 basis points in 10-year
US Treasury yields, after which yields rebounded to normal levels;

The taper tantrum in US treasuries – when between 1 May 2013 and 5 July 2013, US sovereign
bond yields rose rapidly from 1.64% to 2.71%;

The Swiss Franc move – when on 15 January 2015, currency markets were particularly
affected by the appreciation of the Swiss franc by nearly 40% against the euro and the dollar
following the Swiss National Bank’s decision to remove its cap to the Euro;

Sterling flash crash – when on 7 October 2016 the British pound plunged from $1.26 against
the dollar to a little over $1.18 in two minutes – initial market reactions have suggested adeterioration of liquidity in the FX market as a key factor51.

Regulators have in recent years also examined the impact of high-frequency trading. A recent study
by the German Bundesbank, analyzing data from DAX and Bund future contracts, concluded thathigh-frequency trading can amplify financial market volatility52.
We believe a decline in market making capacity is a source of material potential risk in fixed income
markets. Market makers play a key role in bridging the varying requirements– including time
preferences, investment mandates and risk appetites – of investors and users of capital, which areoften highly diverse. Market making services help investors bridge a range of gaps encountered indifferent market conditions, such as risk gaps, inventory gaps and time gaps.
As noted by IOSCO and other authorities, dealer corporate bond inventories are not keeping pacewith the number of bonds available for trading in the secondary corporate bond markets. Following
the financial crisis dealer inventories seem to have recovered but remain below pre-crisis levels. This
could carry important implications for these markets, particularly in stressed scenarios, that we
believe should not be underplayed.
We concur with policymakers that have raised awareness of this concern, for example:


ESRB paper Market liquidity and market-making, October 2016: “Market-making plays animportant role in a market functioning correctly. A key element of market liquidity in bondmarkets, and in corporate bond markets in particular, is market-makers’ ability to absorb
temporary order imbalances by warehousing risk for short periods of time.”BIS CGFS Fixed income market liquidity, No 55, January 2016: “Dealers have continued to cut
back their market-making capacity in many jurisdictions. Demand for market-making

50 Citi paper The liquidity paradox, May 2015
51 Financial Times Pound plummet blamed on ‘liquidity holes’, 10 October 201652 Bundesbank Bedeutung und Wirkung des Hochfrequenzhandels am deutschen Kapitalmarkt, October 2016

(in German only)22

services, in turn, continues to grow. The effects of these diverging trends have, thus far, notmanifested themselves in the price of immediacy services, but rather they are reflected inpossibly increasingly fragile liquidity conditions.”

VI. Summary of major reforms yet to be finalised and theirpotential impact on corporate bond markets
Since the 2007/2008 financial crisis, global and jurisdictional authorities have been implementing a
multi-year regulatory reform programme and introduced a large number of initiatives which aresubstantially reshaping the way financial markets operate.
It is acknowledged by many policymakers that changes to banks’ prudential regulations emanatingfrom the G20 agenda are likely to significantly affect banks’ capacity to intermediate and provide
services such as market making in certain instruments. A reduction in banks’ intermediation
capacity, combined with other factors, could significantly impair secondary market liquidity.
While existing data will factor in the impact of implemented reforms – or those for which market
participants have already adjusted – a number of major reforms underway are likely to have asignificant impact on corporate bond markets. We provide below a non-exhaustive list of the mostimportant reforms yet to be fully implemented.

A.

Prudential reforms

The following reforms emanating from the G20/Basel Committee remain to be fully implemented:






Capital floors;
Fundamental Review of the Trading Book (FRTB);
Net Stable Funding Ratio (NSFR);
Leverage Ratio (LR); andTotal loss-absorbing capacity (TLAC) requirement for banks.

In particular, we believe that the implementation of the FRTB, NSFR, LR and TLAC reforms,
depending on their final calibration carry various probable impacts, including:








Lower dealer capacity;
Lower net liquidity as trading and repo activity contract further;
Higher transaction costs, including for end users;
Less ability to transact especially in less liquid or lower grade issues including for end users;
Greater uncertainty over secondary market pricing and capacity, particularly in respect of
new measures such as TLAC;
Higher market volatility; andLoss of liquidity in corporate bond market could transmit risk to other markets.

All of the above potential effects are likely to be amplified at times of stress.
While the Associations fully support the financial stability objectives of the reform programme, we
believe that the process is at a stage where a forward-looking approach should inform regulators’

23evaluation of the potential market liquidity implications of measures being implemented. We would
also caution against evaluation of the market effects of isolated measures, and instead take a holistic
approach to evaluating the market liquidity impacts of the regulatory programme where possible.

B.

Market conduct & structural reforms

In the European context, we draw attention to two major pieces of legislation which could exacerbate
negative impacts on corporate bond market liquidity.


The introduction of MiFID II will bring significant changes to the way liquidity is defined forthe purpose of trading and transparency requirements. MiFID II includes a range of newtransparency requirements that could increase the risk of exposure for market makers andinvestors to adverse market scenarios, thereby potentially impairing their capacity andwillingness to trade certain instruments. The Associations do welcome the proposed phasing
in of waivers and requirement for ESMA to assess liquidity annually before proceeding to thenext step of the phase in.



Meanwhile, the European Central Securities Depository Regulation (CSD Regulation) statesthat transactions should be bought-in or cash compensated following a certain period of time.
In addition, a daily penalty fee should be levied against the failing party. Our expectation isthat this regulation will discourage trading in bonds and reduce liquidity particularly on lesshigh grade issues due to concern over ability to acquire stock for delivery before buy in period
commences53.

The scope and nature of market making activities have also been specifically addressed incertain regulations – in some cases this has resulted in the introduction of undue restrictions
on the activities of liquidity providers. By way of example:o

The EU Short Selling Regulation includes an exemption for market making activities
from some of the Regulation’s requirements. The text of the Regulation acknowledges
that market makers are often required to take short or uncovered positions toperform their role and that imposing inappropriate requirements on their activities
would result in a significant adverse impact on the efficiency of financial markets inthe EU. However, provisions introduced in subsequent EU-level guidelines havesought a narrow and constraining interpretation of this exemption with the effect oflimiting and preventing legitimate market making activities54.

o

The proposed EU Bank Structural Reform Regulation when first published sought torequire structural separation of market making activity from deposit taking througha carve out of trading activities from universal banks if certain size-based thresholds
are met. Market participants argued that mandatory structural separation may resultin some banks withdrawing from market making activities on EU markets, for EU

53 See AFME’s response to ESMA’s Technical Standards in relation to the CSD Regulation, February 2015; seealso ICMA Impact Study for CSDR Mandatory Buy-ins, February 2015.
54 See AFME-ISDA response to ESMA Call for evidence on the evaluation of the Regulation (EU) 236/2012 of
the European Parliament and the Council on Short Selling and certain aspects of Credit Default Swaps, March
2013.

24

market participants, in EU securities and other financial instruments. The gap would
be filled by other potentially unregulated entities that do not have to comply withsimilar restrictions55.
o

In the US, for example, the Volcker Rule forbids dealers from running positions except
so as to facilitate client trades. It is possible that this has promoted dealers to become
more cautious than previously, and that this increased caution is amplified
particularly on occasions when markets become more volatile. Some market
participants point to prop trading desks serving a role as an uncorrelated source ofrisk-taking, in particular during moments of stress56.

VII. Support for IOSCO’s new transparency project
The Associations welcome the establishment of a new IOSCO project intended to analyze theinteraction between transparency regimes and liquidity. There have been many importantdevelopments since IOSCO published its report on transparency in corporate bond markets back in
2004. As noted above, the MiFID II regime in Europe will overhaul transparency requirements for
non-equity instruments. MiFID II attempts to determine bond market liquidity levels in order tocalibrate waivers for pre- and post-trade reporting, with the average number of daily trades being amain factor. A phased-in approach has been considered for the gradual introduction of thetransparency regime for bond markets, thereby seeking to ensure that the impact of requirements is
assessed annually before proceeding to the next phase of calibration. This will be an important
exercise conducted by ESMA with the potential to provide many insights on the link between
transparency requirements and liquidity.
IOSCO’s analysis is timely in view of transparency regulations introduced in several jurisdictions.
IOSCO may wish to consider the following studies in its analysis.

A.
The Effects of Mandatory Transparency in Financial Market
Design: Evidence from the Corporate Bond Market, September 201357
Summary:This paper studies how mandatory transparency affects trading in the corporate bond market. In July
2002, TRACE began requiring the public dissemination of post‐trade price and volume information
for corporate bonds. Dissemination took place in Phases, with actively traded, investment gradebonds becoming transparent before thinly traded, high‐yield bonds. Using new data and adifferences‐in‐differences research design, the study finds that transparency causes a significant
decrease in price dispersion for all bonds and a significant decrease in trading activity for somecategories of bonds. The largest decrease in daily price standard deviation, 24.7%, and the largest
decrease in trading activity, 41.3%, occurs for bonds in the final Phase, which consisted primarily ofhigh‐yield bonds. These results indicate that mandated transparency may help some investors anddealers through a decline in price dispersion, while harming others through a reduction in trading
activity.

55 AFME Briefing Note EU Bank Structural Reform Measures, April 2014
56 Citi The liquidity paradox, May 201557 http://economics.mit.edu/files/9018

25

B.
Capital Commitment and Illiquidity in Corporate Bonds, July
201658
Summary:
The paper studies liquidity in U.S. corporate bond markets from 2003 to 2014. Despite a temporary
increase during the financial crisis, trade execution costs have decreased over time. However,alternative measures, including intraday and overnight dealer capital commitment, dealer
participation as principals, turnover, the frequency of block trades, and interdealer trading, have not
returned to pre-crisis levels and in many cases have worsened. The reduction in dealers’ commitment
to bond market making in recent years is attributable to bank-affiliated dealers, while non-bankdealers have increased their participation. The evidence supports that these outcomes reflect
unintended consequences of post-crisis regulations focused on banking.

C.
Can Transparency Hurt Investors in Over-The-Counter Markets?,
March 201659
Summary:
The paper examines the efficacy of post-trade transparency regulations like TRACE in over-thecounter (OTC) markets. It is a widely held belief that greater transparency in the trading process
benefits investors by reducing opportunities for their exploitation, but the paper seeks to show that
this need not be the case. Using a multi-period auction based model of trading, the paper seeks todemonstrate that potential counterparties may delay their trades when there is transparency
because they can monitor transaction prices and learn more, before participating. This leads toliquidity dry-ups and increased execution risks for investors with immediate trading needs. The
model seeks to offer an alternative explanation for many of the pronounced adverse characteristics
of OTC markets in recent times, such as diminished liquidity, usually attributed to the exodus of
dealers from the market.

D.
When More Is Less: How Financial Market Transparency Affects
Corporate Investment, March 201660
Summary:
The paper examines how changes in financial market transparency affect corporate investment.
Using a difference-in-differences analysis, the paper finds that increases in price and volumetransparency for corporate bonds reduces corporate investment. Greater transparency reduces firmlevel capital expenditures, R&D expenditures, and cash acquisitions, and increases primary market
bond yields. This reduction in investment is heterogeneously stronger in firms with more volatile
operations, more dependency on external financing, and higher rollover risk. It is also suggested that
greater market transparency is not unambiguously bad for firms. Greater transparency increases
investment efficiency and the sensitivity of investment to bond prices.
58 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2752610
5960

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2746910
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2746452

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VIII. Conclusion
In closing, we would like to reiterate our strong support for IOSCO’s efforts to assess the current
liquidity environment in corporate bond markets.
In this submission we argue that there are sufficient early warning signals to suggest that regulationand other market factors are contributing to a reduction in certain aspects of secondary liquidity incorporate bond markets that is likely to be exacerbated by the unwinding of quantitative easing or
another stressed market situation.
We encourage IOSCO and other regulators to continue building their understanding of the evolutionof liquidity in these markets and the key factors driving structural changes. GFMA and IIF stand readyto assist IOSCO in refining its data analysis and to pursue a forward-looking dialogue with market
participants. As follow up to this submission, we plan to pursue further engagement with IOSCO’s
secretariat and national member authorities to provide assistance and facilitate a platform for
dialogue among policymakers and leading market participants represented in our memberships.
We appreciate the opportunity to comment and your consideration of these views. Please do nothesitate to contact David Strongin, Executive Director at GFMA (dstrongin@gfma.org); Pablo
Portugal, Director at AFME (Pablo.portugal@afme.eu); Brad Carr, Deputy Director at IIF(bcarr@iif.com) or Richard Gray, Senior Policy Advisor at IIF (rgray@iif.com).

The Global Financial Markets Association brings together three of the world's leading financial tradeassociations to address the increasingly important global regulatory agenda and to promote coordinatedadvocacy efforts. The Association for Financial Markets in Europe (AFME) in London and Brussels, the Asia
Securities Industry & Financial Markets Association (ASIFMA) in Hong Kong and the Securities Industry and
Financial Markets Association (SIFMA) in New York and Washington are, respectively, the European, Asian andNorth American members of GFMA. For more information, please visit http://www.GFMA.org.
iii The Institute of International Finance is the global association of the financial industry, with close to 500

members from 70 countries. Its mission is to support the financial industry in the prudent management of risks;
to develop sound industry practices; and to advocate for regulatory, financial and economic policies that are in
the broad interests of its members and foster global financial stability and sustainable economic growth. Within
its membership IIF counts commercial and investment banks, asset managers, insurance companies, sovereign
wealth funds, hedge funds, central banks and development banks. For more information visit www.iif.com.

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