William C Dudley: Market and funding liquidity - an overview
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the Federal Reserve Bank of Atlanta 2016 Financial Markets
Conference, Fernandina Beach, Florida, 1 May 2016.
* * *
Accompanying charts can be found on the Federal Reserve Bank of New York's website.
It is a pleasure to have the opportunity to participate in the Federal Reserve Bank of Atlanta's
21st Annual Financial Markets Conference. This year's topic, focusing on the connection
between liquidity and financial stability, is an excellent one. As the first speaker, I thought it
would be useful to lay out what I see as some of the key issues. I may raise more questions
than provide answers, but, hopefully, my remarks will help to stimulate our discussion and
debate over the next two days.
As I see it, in the context of our financial system there are two distinct types of liquidity. The
first is what is typically referred to as market liquidity. I would define market liquidity as the
cost - both in expense and time - of buying or selling an asset for cash. Market liquidity
reflects a number of factors, including any direct transaction expense, such as brokerage
costs; the price the transaction is executed at relative to the midpoint of the bid-ask spread;
how much, if at all, the transaction moves the market price; and the immediacy or
speediness with which the transaction can be completed.
With respect to market liquidity, there are a number of important open questions. Has market
liquidity declined for some asset classes? If so, what are the causes? In particular, has the
increase in the regulatory requirements imposed on systemically-important securities dealers
adversely impacted market liquidity? If this is the case, are there adjustments that could be
made that might improve market liquidity without impairing financial stability?
The second important type of liquidity is funding liquidity. By funding liquidity, I mean the
ability of a financial entity to raise cash by borrowing on either an unsecured or a secured
basis. Although market and funding liquidity are often treated as distinct, they can be closely
related. This is especially the case during a financial crisis. If funding liquidity declines
because of market stress, for example, this may cause intermediaries to become less willing
to provide market liquidity. Declines in market liquidity, in turn, may further impair funding
liquidity, creating a negative feedback dynamic.
Capital and liquidity requirements play a role in preventing such a self-reinforcing negative
dynamic. The central bank may also have an important role to play as the
lender-of-lastresort. When and how the central bank intervenes - and what the appropriate preconditions
should be to maintain market discipline and mitigate moral hazard - are important open
questions.
As always what I have to say today represents my own views and not necessarily the views
of the Federal Open Market Committee or the Federal Reserve System.1
Turning first to the issue of market liquidity, the evidence that market liquidity has diminished
is mixed. Some market liquidity metrics have not changed much in recent years. For the U.S.
Treasury market, quoted bid-ask spreads in the inter-dealer market have remained stable
since 2010 at their pre-crisis levels (Exhibit 1). And, order book depth, while lower now than
in 2012 and 2013, does not appear low by historical standards (Exhibit 2).2 For the corporate
bond market, some evidence even suggests improving market liquidity. For example,
excluding the financial crisis period, the realized bid-ask spread calculated from TRACE data
has been trending down since the early 2000s (Exhibit 3).3
But these metrics don't tell the whole story. In particular, we have significant data gaps that
make it difficult to comprehensively measure market liquidity. For example, in the U.S.
Treasury market we have poor visibility into dealer-to-customer transactions. In this market
segment, business is conducted bilaterally on an over-the-counter (OTC) basis - typically by
phone or through electronic trading platforms like Tradeweb and Bloomberg that are based
on the traditional request-for-quote model. The U.S. Treasury has issued a detailed request
for information seeking public comment on the many factors that are affecting the structure
and liquidity of the U.S. Treasury market, and is seeking comments on the relevant data
gaps.4 This is an important step that will help clarify what further work is needed in this area.
Even in the corporate bond market where we have detailed TRACE transaction data, this still
tells an incomplete story. TRACE data show what trades have taken place, not what trades
have potentially been foregone because of any possible diminution of market liquidity.
Gaining a better understanding of this phenomenon is being actively researched by my staff.
In contrast to the market liquidity metrics such as bid-ask spreads, indirect evidence on
market liquidity suggests that there has been a decline. Asset managers report that large
blocks of securities are now harder to buy and sell without generating significant movements
in prices. Also, average trade sizes have decreased (Exhibit 4) and there is evidence of a
growing bifurcation in the corporate bond market, with greater activity and liquidity in those
bonds that were issued more recently, larger in size or brought to market by larger issuers.
Also, capital and liquidity requirements for the largest securities dealers - which have been
raised significantly since the financial crisis - might have adversely impacted market liquidity.
These regulatory changes likely have affected the profitability of dealer intermediation
activities and consequently the provision of market liquidity.
For the Treasury market, the most important change in regulatory requirements appears to
be the supplementary leverage ratio (SLR). The SLR limits the leverage of dealer balance
sheets. In the SLR, all assets are treated the same in terms of required regulatory capital.
Consequently, the SLR is much tougher on low-risk assets as compared to the risk-based
capital measures that it complements. This makes the economics of repo-financing much
less attractive. Not surprisingly, we observe significant declines in the quantity of repo
financing by dealers (Exhibit 5).
For the corporate bond market, the most relevant regulatory changes appear to be the
increase in the Basel risk-weighted capital ratio, the Comprehensive Capital and Analysis
Review (CCAR) stress tests and the Volcker Rule - which prohibits proprietary trading for a
number of asset classes such as corporate bonds, albeit not U.S. Treasuries. We do observe
significant declines in recent years in securities dealers' holdings of corporate bonds
(Exhibit 6).
It would be surprising if these declines in repo and corporate bond holdings did not have
some consequence for market liquidity. However, we do not observe marked declines in
dealer holdings of Treasuries, even as overall dealer assets have stagnated (Exhibit 7). The
stagnation in dealer assets might indicate that inventory risk has shifted from dealers to asset
managers and other buy-side participants, reflecting a shift in market-making from a
"principal" to an "agency" model.
While increases in regulatory requirements have undoubtedly played a role, I think that other
non-regulatory factors are also important. Liquidity provision is affected by changes in market
structure, how trades are executed, and by competition from those operating outside of the
regulatory boundaries that have been established for systemically-important financial
institutions. Similarly, the demand for liquidity is also evolving with the growth of large asset
managers, mutual funds, exchange traded funds (ETFs) and principal trading firms (PTFs) -
which are sometimes referred to as high-frequency trading firms. In the U.S. Treasury
market, for example, high-frequency trading firms have seized a large proportion of the
interdealer market in recent years (Exhibit 8). In the credit market, a rapidly rising share of
corporate bonds outstanding is now held by mutual funds (Exhibit 9). Because mutual funds
are not natural providers of intraday liquidity,5 their rapid growth may have contributed to the
decline in secondary market trading activity. Fixed-income market liquidity may also be
declining for cyclical reasons. Dealer inventories have historically been sensitive to changes
in the size of credit risk-premia and term-premia (Exhibit 10). Finally, the effects of
unconventional monetary policy on rate expectations and corporate bond issuance may also
be affecting market liquidity. This is an area in need of further study.
To reiterate, the evidence that market liquidity has diminished is mixed. But even if one
agrees with the position that market liquidity has diminished, concluding that tougher
regulatory requirements are the most important factor would be premature at this stage. The
available evidence and common sense suggest that the changes in the regulatory regime are
likely important, but we need to do considerably more work before we reach a definitive
conclusion on their relative contribution.
Furthermore, even if additional evidence supported the conclusion that market liquidity has
declined due to the increase in the regulatory burden on the major securities firms, this
decline would still need to be weighed against the benefits of a more resilient and robust
financial system. During the last cycle, market liquidity was plentiful prior to the financial
crisis. But, as the financial system became stressed and several large systemic firms
teetered on the brink of failure, market liquidity quickly dried up. A somewhat higher cost for
the provision of market liquidity during the more benign stages of a financial cycle might be
worthwhile if it were accompanied by less volatility and stress when the cycle inevitably
turned down. In fact, even if market liquidity costs are now going to be higher on average,
this might be a small price to pay for a much more stable financial sector.
Also, it is important to recognize that market liquidity conditions a few years from now may be
very different from the situation today. If the cost of providing liquidity services has increased,
this creates strong incentives for innovators to find better ways to match buyers and sellers.
In my view, this innovative response is already underway. For example, in both the Treasury
and corporate bond markets, firms are being established to more efficiently match buyers
and sellers of less liquid bonds in order to reduce search costs and the need to carry
inventory. Furthermore, execution algorithms have been developed that divide large trades
into smaller sizes, thus reducing the costs of moving large blocks of securities. Market
liquidity conditions could very well improve over time as innovation occurs in response to this
new regime.
Let me now turn to the topic of funding liquidity. I think this issue deserves as much attention
as market liquidity. After all, during the financial crisis the demise of several major financial
institutions resulted from their inability to finance their long-dated illiquid assets. The
deterioration in funding liquidity also increased the degree of systemic stress as firms were
forced to sell assets, which depressed their prices, undermining the solvency of firms
throughout the financial system.
As I noted earlier, while funding liquidity can be considered as its own distinct subject, it does
have a direct link back to market liquidity. If firms that trade and invest in securities cannot
obtain funding liquidity, this will likely lead to less transactions volume, thinner markets and
less overall market liquidity. It is also likely to lead to less pricing efficiency resulting in wider
and more persistent disparities in the prices of similar assets. Without access to funding,
leveraged players, such as hedge funds, will find it more difficult to react to transient
dislocations in market prices by engaging in arbitrage - that is, buying the cheaper and
selling the more expensive asset. Without a reliable source of short-term funding, market
functioning can become impaired, which can further disrupt funding and market liquidity.
This can be seen by looking at the relationship between the volume of dealer-funded repo
backed by U.S. Treasury securities versus the size of Treasury bid-ask spreads (Exhibit 11).6
During times of financial crisis - such as in 2008 - sharp deleveraging of dealers' repo books
coincides with an increase in Treasury bid-ask spreads. However, during non-crisis periods,
this correlation is quite low. This relationship between funding and market liquidity is also
evident when we examine the relationship between the dispersion of Treasury yields relative
to a fitted Treasury yield curve and Treasury bid-ask spreads (Exhibit 12). Large dispersions
of Treasury yields from what is implied by a fitted yield curve may indicate funding liquidity
strains, as market participants find it more difficult to arbitrage relative price distortions.7
Again, we see a strong correlation between the sizes of the yield curve errors and of bid-ask
spreads during a financial crisis, but not during non-crisis periods.
The drop in the availability of dealer-funded repo financing also appears to have led to less
efficient arbitrage between closely related asset pairs, such as on-the-run and off-the run
Treasuries, corporate bonds and credit default swaps, and Treasuries versus interest rate
swaps. The price differences or yield spreads between the more capital intensive and less
capital intensive assets have widened.
For example, we can see this in the difference between the fixed-rate paid on a 10-year
interest rate swap and the secondary market yield on a 10-year Treasury note (Exhibit 13).
Whereas historically this spread has been positive - reflecting the fact that an interest rate
swap has more credit risk than a Treasury security - the spread has been negative since
September 2015. Market participants suggest that this shift has occurred because the higher
capital requirements have made it unattractive for dealers to arbitrage away this dislocation.
Similarly, dealers apparently are unwilling to provide the funding and the balance sheet
capacity necessary for their leveraged clients to arbitrage away this dislocation. The degree
to which this shift in the yield spread between Treasury and interest rate swap yields is due
to the differential capital requirements imposed on cash versus derivative instruments
warrants more investigation.
Just as market and funding liquidity are interlinked, so are funding liquidity and capital
requirements. All else equal, stronger capital requirements reduce firms' vulnerability to runs.
This suggests that funding liquidity risk can be addressed in many different ways. First,
capital requirements can be bolstered to reduce the risk that a firm will become insolvent in
particularly bad states of the world. Second, improved reporting and transparency can
reduce the degree of uncertainty about whether a firm is solvent, thus reducing the risk that
investors might wrongly perceive that a firm is insolvent, when, in fact, it still has adequate
capital. Third, liquidity requirements can be increased to reduce the risk that the firm will
have to engage in a fire sale of assets that might deplete its capital. Also, a liquidity buffer
gives the firm's management time to respond to bad events without having to resort
immediately to selling assets. Fourth, a lender-of-last-resort can provide a liquidity backstop
that makes funding liquidity more resilient. Consider the case when a counterparty is
uncertain about how other potential lenders view a firm's solvency. If there is no
lender-oflast-resort backstop, this may cause firms to be unwilling to lend, not because they perceive
the counterparty as insolvent, but, instead, because they are worried about what others think.
That is, I may be unwilling to lend to you, not because I perceive you as insolvent, but
because I am uncertain about how others view your solvency. If I do lend and others don't
share my view, will I be able to get my money back? With a lender-of-last-resort added to the
picture, I no longer need to know what others think. As long as the lender-of-last-resort is
available, if I am correct in my assessment that the firm is solvent, then I can be assured that
I will be paid back.
This issue was particularly relevant during the financial crisis when counterparties even
pulled back from firms that were widely viewed as solvent. The Federal Reserve stepped in
and created funding backstops for a wide array of assets, such as commercial paper and
asset-backed securities. This bolstered the confidence of counterparties in one another and
restored market and funding liquidity. Of course, this type of lending is only feasible to an
institution that is deemed to be solvent with sufficient collateral available to pledge to the
lender-of-last-resort so that it can safely secure its loan.
In practice, all of these methods are in place to address funding liquidity risk. Capital
requirements have been increased; there is much better reporting about how firms will do
under significant stress tests; liquidity requirements - such as the liquidity coverage ratio -
provide a buffer that allows management more time to respond to problems; and, if
necessary, the central bank can act as the lender-of-last-resort to support market confidence
and funding liquidity.
So, should more be done to support funding liquidity? In my view, an important issue is to
identify and address gaps in the lender-of-last-resort function. In the U.S., some significant
gaps remain. For example, the Federal Reserve has a very limited ability to provide funding
to a securities firm, even on a fully collateralized basis. The Discount Window is only
available to depository institutions, and Section 23A of the Federal Reserve Act severely
constrains the ability of a depository institution to pass Discount Window funding along to its
securities affiliate. Although the Federal Reserve may be able lend to a securities affiliate
under its emergency lending authority under Section 13(3) of the Federal Reserve Act, this is
not a standing facility - it can only be established if "unusual and exigent" circumstances
exist and the program or facility must have broad-based eligibility, among other
requirements.8
8
A program or facility has broad-based eligibility only if it is designed to provide liquidity to an identifiable
market or sector of the financial system. The program or facility will not be considered to have a broad-based
eligibility if fewer than five persons or entities would be eligible to participate, or if it is designed to assist a
company avoid bankruptcy, resolution or insolvency (including by removing assets from its balance sheet) or
aid a failing financial company. See Regulation A, 12 CFR 201.4(d). In addition to the "unusual and exigent"
circumstances and broad-based eligibility requirements, other conditions for making Section 13(3) emergency
credit include obtaining the affirmative vote of a requisite number of Federal Reserve Governors and the prior
approval of the U.S. Treasury Secretary, the emergency credit is not extended to an insolvent borrower, the
lending Federal Reserve Bank is secured to its satisfaction, evidence is obtained regarding the unavailability
of adequate credit accommodation from other banking institutions under prevailing circumstances to
borrowers of the emergency credit, penalty interest rate is set for the emergency credit, and meeting
disclosure/reporting requirements. See Section 13(3) of the Federal Reserve Act (12 USC 343) and
Regulation A (12 CFR 201.4(d)).
In the U.S., given the restrictions on central bank lending, if a securities firm were to lose
access to funding the remaining options available would be finding a means of replenishing
the firm's capital, selling assets, or selling all or part of the securities firm's operations. While
this might be manageable in the case of a firm-specific idiosyncratic shock, it might prove
more difficult if a common shock was broadly hitting the securities industry. In this
circumstance, the failure of one firm could increase the stress on other firms that were facing
similar difficulties. If all of the requirements for Section 13(3) are met, the central bank could
provide liquidity support. However, since this is not a certainty, it is worth considering
possible alternatives. Now that all major securities firms in the U.S. are part of bank holding
companies and are subject to enhanced prudential standards as well as capital and liquidity
stress tests, providing these firms with access to the Discount Window might be worth
exploring. To me, this is a more reasonable proposition now than it was prior to the crisis
when the major dealers weren't subject to those safeguards.
More generally, I am happy to report that the Committee on the Global Financial System -
one of the Bank for International Settlements' central bank groups - is engaged in a project
to determine what lender-of-last-resort gaps currently exist, focusing, in particular, on those
that may create vulnerability in terms of financial stability. One area that I anticipate will
receive considerable attention is whether there are any gaps with respect to the activities of
globally systemic firms that operate on a cross-border basis.
Another issue that still needs greater attention is the appropriate role for the home- versus
host-country supervisor. The regulatory and supervisory responses for large,
systemicallyimportant firms that operate on a cross-border basis need to be closely coordinated,
especially during times of stress. In particular, expectations about who will be the
lender-oflast-resort need to be well understood in both the home and host countries.
We have made considerable progress in recent years in enhancing the safety and
soundness of the U.S. financial system. But there is more that we need to do. In particular,
we need to study and understand how market liquidity and funding liquidity conditions are
changing and what factors are driving that evolution. Conferences like this one go a long way
in that regard. They serve as an important forum for discussing ideas and improving our
knowledge and understanding. This will provide a solid foundation for any policy actions.
Thank you for your kind attention. I would be happy to take a few questions.