Chris Salmon: Financial market volatility and liquidity - a cautionary note
Speech by Mr Chris Salmon, Executive Director for Markets of the Bank of England, at the
National Asset-Liability Management Europe symposium, London, 13 March 2015.
* * *
I would like to thank Andrew Butcher, Jonathan Rand, Allison Parent, Joseph Noss, Olga Cielinska, Liam
Crowley-Reidy, Sebastian Vismara, Lu Liu and Yuliya Baranova for their comments and contributions.
As Executive Director for Markets at the Bank of England it is my job to manage the balance
sheet, implementing various policy decisions that the Bank makes. I am also responsible for
ensuring that the Bank extracts as much "market intelligence" from financial market
developments as is possible to inform those decisions. But it's not my job to set policy.
Given that, my remarks will focus on the key insights we have drawn from financial market
developments over the past year or so, in the context of what has been quite a dynamic
period for monetary policy. But I will not speculate on the future course of policy by the Bank
of England or any other central bank, nor the likely effectiveness of the different strategies
employed by central banks to achieve their targets.
And my punch line will reveal me to be the central banker that I am: there are reasons to be
cautious. In particular, recent periods of financial market volatility suggest that there are
reasons to be cautious about the robustness of liquidity in core financial markets.
To set the scene let me return to the middle of last summer, when volatility was exceptionally
low across a range of financial markets; both compared to the period of heightened volatility
that we saw in the crisis years and the period preceding it. That can be seen from this spider
chart which shows measures of short-term implied volatility for a number of assets relative to
these two periods. Anything less than zero is less volatile than the past, with the opposite
true for positive plots (Chart 1).
Our market intelligence suggests that a number of factors contributed to these stable
outcomes. There was a relatively low level of uncertainty about the macroeconomic outlook.
The extraordinary policy easing from central banks had depressed both implied and realised
volatility. Forward guidance, as well as repeated rounds of quantitative easing had also led to
market participants to take comfort from the mantra of "low-for-long". This in turn incentivised
investors to "search for yield", which of course was an intended consequence of the
monetary stance, but which depressed volatility and compressed risk premia in a
selfreinforcing cycle.
Since last summer volatility in many financial markets has picked up and there have been a
number of short-lived episodes of extreme volatility and impaired market liquidity. Implied
volatilities have risen and in a number of the cases I showed earlier have returned to around
pre-crisis levels (Chart 1). Moreover, longer-term measures of volatility have generally
increased alongside shorter-term measures, as this chart which plots 2-year implied
volatilities alongside 3-month volatilities suggests (Chart 2).
We have also witnessed some very large moves in financial markets over the past
six-months. Here I am going to draw on two examples - the 15 October increase in US
Treasury yields following the publication of unexpectedly weak US retail sales data, and the
15 January appreciation of the Swiss franc following the SNB's decision to remove its peg to
the euro. The events had different drivers, but there are some common themes I would like
to draw out.
What unites the 15 October and 15 January episodes is that the immediate intra-day reaction
to the news was unprecedented. The intra-day change in 10-year US bond yields was
37 bps, with most of this move happening within just an hour of the data release. The
intraday range represented nearly eight standard deviations, exceeding the price moves that
happened immediately following the collapse of Lehman Brothers. On 15 January, the Swiss
franc appreciated by 14%. The intraday range was several times that number, and market
participants continue to debate the highest traded value of the franc on the day.
Such events could imply that a number of major asset markets may have become more
sensitive to news, so that a given shock causes greater volatility. A number of recent
statistical studies also imply this conclusion, suggesting that these recent episodes are a part
of a broader pattern, even if they were exceptional in their scale. The following chart, using
the output of a model estimated by Bank staff, is representative of the statistical analysis just
referred to1. The chart compares the estimated impact on UK equity and corporate debt
asset price volatility of a given price shock in the post-crisis period relative to the pre-crisis
period (Chart 3). Post crisis, both corporate debt volatility and equity market volatility appear
to have become more responsive to a given price shock. This pattern is also apparent when
the model is applied to a number of other important asset markets, including for example
US-listed equities.
Liquidity was clearly affected on each of 15 October and 15 January. Measures of trading
volumes, which provide one metric of liquidity, were reportedly high on both days for most
affected markets. But the ability of market participants to trade without affecting prices, or in
some cases, to trade at all, was clearly very limited at various points on these days. The
intra-day loss of liquidity was probably even starker on 15 January, from what we can tell,
with widespread feedback that foreign exchange trading platforms stopped quoting Swiss
francs for periods of time, while liquidity in the Swiss fixed income market was all but lost on
the day and remained impaired for a few days. The performance of the US Treasury market
was also materially affected on each of these days, such that much smaller trades than
normal moved prices.
But in each of these cases there were stabilising forces that meant volatility subsided and
liquidity returned relatively quickly. In the case of the 15 October event, what had been a
crowded trade was pushed so far from prices viewed as "justified" by fundamentals that
market participants were willing to provide support to the market. Similarly there was a
reappraisal of the fundamentally justified level of the Swiss franc in the days that followed the
removal of the peg, following public comments by the SNB. Volatility declined, if not all the
way back to the pre-news level, relatively quickly following these initial spikes. This is most
true of the 15 October episode: the implied volatility of 10-year interest rate swaps retraced
about half of its upward move after two days, and was back to pre-October 15th levels within
just two weeks. This quick stabilisation helped to limit contagion to other markets.
Neither the increase in "baseline" volatility, nor the recent episodes I have just described, in
of themselves materially affected stability in the United Kingdom. For us then, the question
becomes what lessons can we learn? Why have volatility and liquidity evolved in this way?
And is there an important "So what?"
Starting with the "Why?", market intelligence suggests that uncertainty surrounding the global
outlook has been one factor; itself in no small part a consequence of the unexpected rough
halving in the price of oil since last summer. This uncertainty can be seen in the recent
increase in the dispersion of economists' forecasts for inflation in the US, UK and euro area
during 2015.
Central banks themselves have reacted to the changed global outlook and monetary policy
makers have been active in recent months. Indeed, so far this year 24 central banks have cut
their policy rates. Moreover, the decisions by the ECB and three other central banks since
last summer to set negative policy rates have raised questions about where the lower bound
for monetary policy exists. Clearly the answer is no longer as simple as just above zero for all
central banks. And those decisions are raising questions about how markets work when
negative rates persist several years down the yield curve (Chart 4). The combination of this
macroeconomic news and central bank action means the assumed known of "low-for-long"
(but positive) policy rates which market participants could cite as little as a year ago has
been replaced by a less than certain landscape, helping to explain why "baseline" volatility
has picked up since last summer.
But while this increase in macroeconomic uncertainty and central bank activity can explain
some of the general increase in the level of volatility, it cannot explain the severity of events
such as 15 October or 15 January. To explain these events we probably need to look
elsewhere. The obvious place to turn to is market structure, given that FICC markets, which
rely on intermediaries to make markets and warehouse risk, are going through considerable
change.
Here I want to highlight two important contributing themes noted by market participants in our
Fair and Effective Markets Review, both related to the provision of liquidity. First, market
makers have become more reluctant to commit capital to warehousing risk. During our
market intelligence conversations some have suggested that this reflects a combination of
reduced risk tolerance since the financial crisis, and the impact of regulation designed to
improve the resilience of the financial system.
This reduction in market making capacity has been associated with increased concentration
in many FICC markets, as firms have been more discriminating about the markets which they
make, or the clients they serve. And this trend has gone hand-in-hand with a growth in
assets under management by the buy-side community. The combination has served to
amplify the implications of reduced risk warehousing capacity of the intermediary sector
relative to the provision of liquidity from market makers during times of market stress relative
to the past.
That said, I would hesitate in drawing too much of a comparison between the market liquidity
of today and that of pre-crisis. You don't need a long memory to recall the impact of
underpricing liquidity risk on the highly leveraged market makers. Returning to such a situation
would be a misplaced aspiration.
The second theme I want to draw out is the evolution of market micro-structure. Electronic
platforms are now increasingly used across the various FICC markets. In some cases
regulation has been the cause but in others, such as foreign exchange markets, firms have
over a number of years increasingly embraced electronic forms of trading. This includes
using "request-for-quote" platforms to automate processes previously carried out by phone.
Electronic platforms are effective in pooling liquidity in "normal" times but may have the
potential, at least as currently calibrated and given today's level of competition, to contribute
to discontinuous pricing in periods of stress if circuit-breakers result in platforms shutting
down. There has been much commentary about the temporary unavailability of a number of
electronic trading platforms in the immediate aftermath of the removal of the Swiss franc peg.
A contrarian view, which I do not ascribe to, would be that no explanation is required. The
argument would be that the apparent change in ability of markets to digest news is a mirage:
the statistical analysis would prove to have captured a transient trend, and that
intermediaries were never prepared to stand in the way of large market moves, during good
times or bad. On this view, the reduction in balance sheet and the move towards electronic
structures have been correlated with, but are not a cause of, the events we have seen. And
the fact that the spikes in volatility have been visible in equity as well as bond markets, where
market structure has not undergone as profound change as FICC markets, would be taken
as supporting evidence. This view would caution against over-interpreting a few isolated
case studies, where excessive market conviction - that the next move in US rates would
definitely be up; and the Swiss peg was immutable - led to highly crowded trades
accentuating the price moves and the impact on volatility.
But this is not the interpretation I lean towards. Not least because we hear from market
participants that, far from biting in extreme circumstances, these are issues that FICC
businesses are grappling with on a daily basis. An eight standard deviation move in
US Treasuries, on weaker-than expected US retail data, lies outside the bounds of what
could be considered a transient trend. Consolidation and electronification have plausibly
combined to accentuate the sharp moves seen last autumn and this January. The apparent
increase in the incidence of such spikes in recent months may be because the "comforting
cloak" of "low-for-long" has been less of a factor in suppressing volatility in preceding
months.
Turning to the "So what?", it is definitely not that the rise in volatility that is a concern per se:
if anything, policymakers have long been concerned about the potential financial stability
risks associated with a long period of low volatility. Even with the recent rises, volatility in
most asset classes is only close to the average level of the pre-crisis period; a period which
after the fact proved to have been associated with the under-pricing of risk and suppressed
market volatility.
Nor is it that necessarily the case that some decline in the liquidity of financial markets would
be a concern: the correct answer is not always maximal liquidity as I noted earlier. We are
unlikely to return to this pre-crisis world and should not see it as an aspiration.
But, if we accept the hypothesis that the market's ability to digest significant news has
changed such that sudden increases in volatility and loss of liquidity are more likely, then the
concern is that the stabilising factors which dampened the impact of such events in recent
months may not always kick-in. In those circumstances the period of market dislocation could
become more persistent, increasing the scope of spillovers across financial markets, with
potentially more significant impacts for financial stability.
Put another way, recent months have shown the potential for short, sharp shocks. But
financial markets may not have been truly tested for the ability to absorb price moves or
flows that persist for a prolonged period, or for a wider spillover between markets. As such,
the "So what?" is that market participants need to take note of the recent periods of volatility
and illiquidity and remain aware of the possibility of these events occurring more frequently,
and the potential for them to have more persistent effects. As the Bank's December Financial
Stability Report concluded, "Adjustments will be more disruptive if investors' pricing of
liquidity risk does not fully reflect structural changes in market liquidity."
In conclusion, financial market conditions have changed quite noticeably over the past year
or so. In part this is conjunctural: the macroeconomic outlook has changed and perhaps
become less certain. Central banks have reacted, and in some cases pushed the innovation
envelope further. Unsurprisingly these developments have been associated with more
volatile financial markets. Given that policy-makers have previously been concerned that
persistently tranquil financial markets could encourage excessive risk-taking, this
development is not necessarily an unwelcome development. But recent months have also
seen a number of short episodes of sharply-higher volatility which coincided with periods of
much impaired market liquidity. There are good reasons to believe that the severity of these
events was accentuated by structural change in the FICC markets. There must be a risk that
future shocks could have more persistent and more widespread impacts across financial
markets than has been the case in the recent past. One tool available to all central bankers
to address such concerns is to raise awareness, so that traders appropriately price risk.
And that is why it is only fit and proper for me to finish on a cautionary note: market
participants take heed.
Appendix
Chart 1
Option-implied volatilities across selected asset classes
Pre-crisis: 01 Jan 2003 - 08 Aug 2007
Crisis: 09 Aug 2007 - 31 Dec 2009
Jun 2014 FSR: 26 Jun 2014
11 Mar 2015
USDGBP
Gold JPYUSD
1.5
Oil USDEUR
0.0
EM FX FTSE 100
-1.5
-3.0
Japan long rates S&P 500
Japan short rates Nikkei 225
US long rates UK short rates
US short rates UK long rates
Sources: Bank of England, Barclays Live, Bloomberg and Bank calculations.
(a) Number of standard deviations from historical mean of three-month implied
volatilities. Historical means calculated over the period since 2003.
Longer-term measures of option-implied volatility
GBP/USD 3m option volatility
GBP/USD 2y option volatility
3m S&P variance swap rate
2y S&P variance swap rate
Basis points
Per cent
3m10y normalised imlied vol on USD IR (LHS)
160 45
2y10y normalised imlied vol on USD IR (LHS)
40
140
35
120
30
100
25
80
20
60
15
40
10
20
5
0 0
Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15
Sources: Barclays Live, Bloomberg.
Implied volatilities are "normalised" by the level of interest rates, so the data show the volatility of absolute (rather
than percentage) changes in swap rates.
Impact of asset price news on volatility in UK equity and debt markets
Pre-crisis credit (Jan 2001 - Jun 2007) Conditional daily
volatility (%)
Post-crisis credit (April 2009 - Jan 2015)
1.8
Pre-crisis equity (Jan 2001 - Jun 2007)
1.6
Post-crisis equity (April 2009 - Jan 2015)
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
-3% -2% -1% 0% 1% 2%
Unexpected daily change in price (per cent)
Sources: Bank of American Merrill Lynch, Thomson Reuters Datastream and Bank calculations.
Negative rates in European government bond markets
Positive Negative
Maturity (years)
1 2 3 4 5 6 7 8 9 10
Switzerland -0.89 -0.99 -0.81 -0.61 -0.47 -0.38 -0.32 -0.29 -0.24 -0.11
Germany -0.27 -0.25 -0.24 -0.21 -0.16 -0.09 -0.02 0.05 0.13 0.20
Finland -0.20 -0.18 -0.15 -0.11 -0.08 -0.06 -0.03 0.09 0.14 0.22
Netherlands -0.18 -0.15 -0.13 -0.07 -0.05 0.00 0.07 0.17 0.26
Denmark -0.80 -0.62 -0.31 -0.04 0.15 0.26
Austria -0.16 -0.17 -0.17 -0.12 -0.06 -0.05 0.02 0.12 0.19 0.29
Belgium -0.16 -0.16 -0.13 -0.08 -0.06 0.02 0.15 0.24 0.34 0.43
France -0.19 -0.20 -0.16 -0.09 0.01 0.08 0.18 0.27 0.36 0.45
Sweden -0.16 -0.17 0.01 0.24 0.44 0.61 0.73
Spain 0.07 0.10 0.18 0.28 0.47 0.63 0.74 0.88 1.05 1.15
Italy 0.03 0.11 0.23 0.36 0.50 0.65 0.79 0.93 1.06 1.19
Norway 0.73 0.76 0.92 1.16 1.34 1.45
UK 0.35 0.59 0.87 1.12 1.31 1.47 1.61 1.72 1.82 1.91
Bloomberg and Bank calculations