Guy Debelle: Liquidity in Australian fixed income markets
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of
Australia, to the 4th Australian Regulatory Summit, Sydney, 21 June 2016.
* * *
Thanks to Jon Cheshire for his work locally and globally on this topic.
Fixed income markets in many jurisdictions have been going through a period of change,
resulting in a debate as to whether they are continuing to function effectively and, in
particular, function effectively in times of stress. Changes in dealer business models and
increased use of electronic trading platforms are influencing the nature of liquidity in bond
markets. However, these changes are not as prevalent in Australia as they are in some
markets overseas, and that is what I am going to talk about today.
Globally the debate on bond market liquidity has been ebbing and flowing over the past
couple of years. You can hear that it is simultaneously the best of times and the worst of
times for liquidity in the bond market. Or to stick with the water analogy that is so prevalent in
such discussions, the market is awash with liquidity at the same time as the tide is going out.
As an aside, the water references in liquidity discussions are as pervasive as they are in
Pixies' songs.
I discussed some of these issues in a speech last year1 and there have been two recent
publications from two BIS Committees that I am a member of that provide a comprehensive
account of recent developments in bond market liquidity globally.2 Rather than recount the
global discussion, instead I will try and make it more directly relevant to this audience and
run through some of the factors affecting Australian fixed income markets, drawing on work
done by my colleague Jon Cheshire published in the RBA Bulletin last week.3 The
assessment that Jon makes, which I share, is that liquidity in most segments of the physical
bond market in Australia is lower than it has been in the past. That is, it is generally a little
more costly to transact in the same volumes, with immediacy, in the Australian bond markets
than it used to be. These changes are partly a response to regulation and partly a
reassessment of business models by banks. But, given that liquidity was oversupplied and
underpriced in the years prior to the global financial crisis, these changes in liquidity are
broadly desirable and, to date, have not presented any significant issues in the Australian
market.
Measuring liquidity
What do we actually mean by bond market liquidity? Often participants in this debate talk at
cross purposes using different metrics of liquidity, so let me explain how we are assessing
bond market liquidity. Market liquidity is the ability to execute transactions in size,
immediately, at low cost and with limited price impact. As you can see, there is both a
quantity and time element to liquidity which is often conflated in discussions about it.
Given these different dimensions to liquidity, measuring it precisely is not a straightforward
exercise. This is particularly the case in Australia, where much of the secondary market
activity is not conducted on electronic platforms and so the trade data is less readily
available. It would be good to see more trade data on transactions in the market, although, in
saying that, it is possible to have too much transparency in this regard. This is particularly so
in a relatively small fixed income market like that in Australia, where the revelation of market
participants' positions in close to real time can be problematic.
The first metric I will use to illustrate developments in liquidity is turnover; that is, the quantity
dimension. I will discuss the price aspect below. A smaller share of the stock of outstanding
bonds is being transacted relative to the past (Graph 1). The turnover ratio (the ratio of the
value of transactions undertaken in bond markets over the course of a year relative to the
average outstanding stock of bonds on issue over the year) for government bonds has
declined from an average of around five in the decade prior to 2012, to a little above three
over the past four years. However, over the same time, the supply has grown significantly, so
that the absolute amount of turnover hasn't changed all that much. The turnover ratio of
corporate securities has declined to a little above one in the decade prior to 2012 to its
current level of about a half.
Graph 1
Looking at this another way, the share of the government bond market that used to turnover
in an average month now takes a bit over six weeks, while the average share of the
corporate securities market that used to turnover in one month now takes closer to two
months. We also hear from market participants that it is, in general, a bit more difficult to
transact in size.
Should we be concerned about this? Not necessarily. The corporate bond market in Australia
has never had a highly liquid secondary market. It has always been predominantly a buy and
hold market, and most participants are well aware of this. More generally, bond market
activity in Australia has been structurally declining over a long period. In the mid 1990s, the
turnover ratio for government bonds was around 10, by the late nineties this had fallen to
around 7. A decade later in the mid 2000s, it had fallen to around 5 and now it is 3. There are
number of explanations for this decline in turnover which I will now turn to.
Derivatives
Market participants have been increasingly transacting in derivative instruments rather than
the cash bonds. Since the mid 1990s, activity in bond futures and interest rate swaps,
relative to bonds outstanding, has increased sharply (Graph 2). In 2015, the value of turnover
in bond markets was around $A21⁄2 trillion whereas the value of turnover in both the
Australian dollar interest rate swaps and bond futures markets was each around $A9 trillion.4
Growth in activity in these markets in recent years has significantly outpaced growth in
issuance of Australian dollar bonds. Overall, the increase in derivative activity has more than
offset the decline in bond market activity.
Graph 2
There is a clear preference for bond issuers and investors in Australia to manage the risk
associated with their bond issuance or bond holdings by transacting in the derivative
instruments rather than in the physical instruments.5 This has resulted in a further
concentration of liquidity in the derivative instruments and a decline in liquidity of cash
instruments. This development is likely to continue to occur, particularly for less liquid
segments of the bond market.
This is occurring because these standardised derivative instruments can be significantly
cheaper to transact than the physical instruments. One of the reasons for this is simply that a
physical transaction has a larger cash component than a derivative transaction. This cash
component has to be funded. If the cost of funding is relatively high, market participants are
likely to shift activity into other instruments. That said, fixed income derivative markets cannot
act as a perfect substitute for bond markets because they are not a funding source for the
seller nor do they represent an investment for the buyer. The underlying bonds still have to
be issued!
Electronic trading
The share of derivative market transactions relative to cash transactions is larger in Australia
than in European and North American fixed income markets. This presents a challenge for
local bond markets to compete for business with the derivative markets. How could this come
about? One way is to look to lower the cost of transacting in bond markets. This could
happen if a greater share of transactions were conducted via electronic trading platforms.
Electronic platforms typically offer a lower cost structure than traditional phone dealing.
The share of electronic trading in government bond markets in Australia is around a third. But
in European and US bond markets the share of electronic trading is considerably greater at
over fifty per cent. In the bond futures markets most trades are conducted via an electronic
platform while around 25 per cent of interest rate swap transactions occur via electronic
platforms. There appears to be scope for a greater share of trading in Australia's government
bond market, at least, to take place on electronic platforms.
The price of liquidity
Having talked so far about the stock of liquidity, I will now turn to developments in the price of
liquidity. While turnover appears to be lower in bond markets, the price of transacting doesn't
appear to be much different from where it has been in the past. This is apparent from bid-ask
spreads, which is a measure of the difference between the price that a buyer is willing to pay
for a typical amount of an asset and for which a seller is willing to sell. Bid-ask spreads have
been narrowing or are around their narrowest in domestic government bond markets. Part of
the explanation is that there has been a decrease in the volume that can be transacted at
these spreads, as a consequence of both increased electronic trading and decreased
principal-based market-making. So spreads are narrower but how much you can make use
of these narrower spreads when trading larger volumes is not so clear, and this is often at
the root of the divergence in opinion about the current health of markets.
Other measures of the price of liquidity also paint a positive picture. For instance, spreads on
risky bonds over government bonds are above levels that prevailed in the years leading up to
the financial crisis, but significantly lower than the average or extreme levels seen during the
crisis years. Volatility too has been a bit higher in the past six to twelve months, but has not
reached levels seen in the crisis.
One reason why Australian fixed income markets continue to function smoothly is that the
derivative markets have been operating effectively. For instance, the market depth (the size
of a trade that can be executed for a given trade size) in the futures market appears to be
similar to levels that prevailed prior to the financial crisis (Graph 3). As I mentioned, these
markets account for the bulk of activity in Australian markets. As such, they play a key role in
price discovery and in facilitating a transfer of risk among market participants. While part of
the concern in global markets is over a withdrawal of market-making activity from bond
markets, it is apparent that this issue has not been as important in Australia for some time.
Graph 3
The role of market makers
The Australian bond markets still rely relatively significantly on market makers who have a
dominant presence in the markets. For instance, according to AFMA data, banks account for
around 45 per cent of all trades in the Australian Government Securities (AGS) market, down
from around 60 per cent in the decade to 2011. At 45 per cent, banks account for a slightly
larger share of transactions in the semis market than they did in the past. Their share of
transactions in non-government bond markets has declined slightly from 50 to 45 per cent.
While in aggregate, banks are still significantly involved, there have been some shifts in the
composition of this activity. Australian bond markets have traditionally had a mix of both local
and foreign banks, although the number of institutions involved in the bond markets has
ebbed and flowed with the size of markets. There was an increase in participation by foreign
banks in 2010 and 2011, partly in response to increased demand from their offshore clients,
who sought to capitalise on the strength of fixed income markets in Australia relative to those
in other jurisdictions. This led the domestic market to be oversupplied for a while in my
opinion. More recently, we have seen some foreign participants leave again as it has
become uneconomic for them to continue to provide market-making services. As a result,
while bond markets are currently larger, relative to GDP, than in the past, the foreign bank
presence is a little smaller than it has been at some times in the past.
The decline in the presence of foreign banks reflects both a change in business strategy and,
in some cases, the effect of regulations. For many banks operating in Australia, the effect of
regulations such as increased capital requirements and the leverage ratio have not been
binding on their business models. Nevertheless, just as has happened in the larger fixed
income markets offshore, banks operating in Australian bond markets have changed their
business models. This has seen a lower level or greater rationing of principal-based
marketmaking as a result of a decrease in appetite to warehouse risk, particularly bonds that are not
very liquid.
This is evident in the bond inventories that banks hold in their trading books. Banks have
decreased the stock of non-government bonds they hold in their trading books and increased
the share of government bond holdings. This is partly driven by a decrease in willingness to
warehouse bonds that do not trade actively in the secondary market. It also reflects the
incentives for banks to hold government bonds to satisfy the Liquidity Coverage Ratio (LCR).
Banks' holdings of government bonds have increased to around 30 per cent of the market.
The RBA's judgement is that a greater holding than 30 per cent may impair the functioning of
the government bond markets. In coming to that assessment, one of the considerations is
the sizeable share of government securities held by offshore investors. In the case of AGS,
this currently amounts to more than 60 per cent of the stock. Many of these investors are
buy-and-hold investors. They generally do not undertake securities lending. As a result,
these bond holdings are not contributing to the liquidity of the market. Hence, a more
relevant metric in considering the share of the government bond market that banks can hold
to meet the LCR is the stock of bonds held by domestic investors.
Last week, the RBA published its latest assessment of the amount of AGS and semis that
could be reasonably held by the domestic banks without impairing market functioning.6
(APRA then sets the aggregate size of the Committed Liquidity Facility as the difference
between the LCR requirements of the banks and the amount of AGS and semis that can be
reasonably held.) We have maintained the assumption that the domestic banks can
reasonably hold a quarter of the stock of AGS and semis in 2017. Foreign banks operating in
the local market hold around another 5 per cent of the stock to meet their LCR requirement.
So, in total, this remains at 30 per cent. Based on budget projections of the Commonwealth
and State governments, we expect that the domestic banks could reasonably hold
$220 billion without impairing the market, which would be an increase of $25 billion
compared to the holdings in 2016.
High frequency trading
High-frequency trading is not as prevalent in the domestic bond markets as it is in some
markets There are mixed views on the contribution of high-frequency trading to market
functioning, particularly in terms of its contribution to flash events in the bond market such as
occurred in the US Treasury market on 15 October 2014 and the German "bund tantrum".7
High-frequency trading does not have a presence in the physical bond market while it has a
modest presence in the bond futures market, growing to around 15 per cent over the past
few years. That said, high-frequency trading activity in the domestic market is often
concentrated around particular events, most notably the bond futures rolls. The share of
high-frequency trading around the futures roll can be considerably higher.
The presence of high-frequency traders can reduce the costs, in terms of spread, of
transacting small parcel sizes. There is evidence of that occurring in the domestic market.
But, high-frequency trading firms do not hold trading positions for a long period of time.
During periods when market prices are adjusting, the presence of market participants that
have longer holding periods can be beneficial because these participants absorb some of the
order imbalance. One possible concern for the future evolution of the bond market is that
high-frequency firms reduce the return to market-making activities in normal (benign) times
causing market makers to exit as such activity becomes uneconomic. This reduction in
market-making then becomes problematic in more turbulent times exacerbating market
disruption. This is a potential development we will be monitoring, although there is no
evidence that this has been an issue to date in the local market.
Conclusion
In conclusion, Australian fixed income markets have continued to function satisfactorily, even
while in some overseas markets there has been increased concern about the capacity of
such markets to function effectively. As I've noted, part of the explanation for the difference is
that the withdrawal of dealers from the bond market in Australia has not been as sizeable as
it has been elsewhere. Regulatory change has contributed to the reduced capacity in the
domestic market, but not to the detriment of market functioning. Indeed, the fact that the
price of liquidity now more accurately reflects the cost of providing liquidity is a positive
outcome.
Another development that has contributed to the satisfactory outcomes in the domestic
market is that a large share of market activity is undertaken in derivative markets that don't
rely as much on market-making capacity and are relatively low cost and efficient.
It is likely that fixed income markets in Australia will continue to evolve in coming years,
which will require market participants to keep adapting. On our side, we will continue to
monitor this evolution and its impact on the efficient functioning of the market.