Faulty Plumbing: 

Market Liquidity and 

Recent Impairment 

Hari Hariharan

NWI Management

13th IMF Public Debt Management Forum and 

3rd U.S. Treasury Roundtable on Treasury 

Markets and Debt Management

June 20, 2013
What Drives Liquidity?

Capital Leverage

Trust

• Confidence

• Redemptions

• Fundamentals

Liquidity =

* *

Today v. 2008:

• Capital stock is lower, though 

rebuilding.

• Leverage is vastly reduced.

• Several factors have recently 

damaged trust:

– Specter of QE tapering

– Regulation-mandated 

attenuation of bank balance 

sheets

– Worsening macro fundamentals

These asset classes merit particular 

consideration:

• Local Currency Bonds

• Interest Rate Swaps

• Credit Default Swaps

• EM FX Options

Trends Transforming the Landscape

• Dramatically enlarged 

participation of non-dedicated 

players

• Disappearance of shadow 

banking/synthetic credit
Liquidity and 

Market Discontinuities

10-Year ZAR Swaps
Pre-Crisis: Large, Diverse Banking Sector 

Provides Bidirectional Liquidity

“Foreign” 

Asset 

Managers

Local 

Institutional 

Buyers

Issuers

• Sovereigns/

Corporates

Sell Side

• Market making

• Liquidity provision

• Risk distribution

• Risk warehousing

Shadow 

Banks/SIVs
Crisis Responses Catalyze 

Unintended Consequences

Bleak

MacroRealities

• Collapsing

aggregate

demand

Procyclical

PostCrisis

Policy

Decisions

QE

• Forced

liquidity

expansion

One-Sided

Market

• Everyone’s a buyer

Widespread

Search

for Yield

• Institutions and 

retail join the fray

Liquidity 

Impairment

• Capital requirements 

(Basel III, CRD4)

• No prop trading 

(Volcker Rule)

• Operating constraints

(Dodd–Frank, CCP )

• EU CDS naked 

short-sale ban

• Demise of shadow

banking/SIVs

• Hedge funds under

attack

Sell Side 

Becomes 

One-Way

Valve

• Less willing to

warehouse

risk

Now

• End of QE 

looms. 

• Concentrated 

large positions 

face inadequate 

exit routes.
Now (QE World): Smaller, Consolidated 

Banking Sector Unable to Meet Liquidity 

Needs of Enlarged Market Players

Sell Side

“Foreign” 

Asset Managers

• Larger, more concentrated, 

less liquid positions

• Long-only buy side Issuers

• Sovereigns/

Corporates

Local 

Institutional 

Buyers

• Larger domestic 

banking systems

• Expanded institutions

“Recency” Effect

One-sided flows make 

entry easy but exit difficult

Where are the 

shadow banks?

Decreased Volumes

Illiquid markets become 

even more illiquid
Is the Solution a Paradigm Shift?

QE

Ends

Realities of

New

Regulatory

Regime

EITHER

1. New interconnections between players.

2. More active role for central banks 

and issuers (liability management, buybacks).

3. Regulatory forbearance and shift away 

from conception of “evil” hedge funds.

4. Involvement of retail.

OR

Leave it to the market – price clears.

Fragile circumstances 

demand difficult choices.
Possible Solution: Interconnected Players 

of Comparable Size Enhance Liquidity

Issuers 

(Sovereigns/

Corporates)

• Liability Management

• Volatility Smoothing

Local 

Institutional 

Buyers

“Foreign”

Capital

• Retail

• Institutional

Clearinghouse

Sell Side
Points to Ponder

How will the IMF respond to this new strain of virus?

• Specific programs for countries plagued by inelastic current 

account balances?

• A special focus on turbulence in local-currency fixed income unrelated to 

macro fundamentals?

• A standardized regime for defaulting sovereigns?

• Procyclical pension fund risk management further confounds the liquidity mix.

• Is expanded retail activity in all asset classes a necessary condition for 

liquidity improvement?

• Shadow banking, for all its evils, provided speculative liquidity and shock 

absorption. What will replace it?

• Central banks have historically monitored FX volatility, but now must deal with 

interest rate volatility as well.