guy debelle : bond market liquidity, long - term rates and china speech by mr guy debelle, assistant governor ( financial markets ) of the reserve bank of australia, at the actuaries institute “ banking on change ” seminar, sydney, 16 september 2015. * * * i am going to talk about three key current issues in financial markets, namely bond market liquidity, long - term interest rates and china ’ s exchange rate regime. all three are having an important bearing on financial market prices round the world, including here in australia, both now and probably for quite some time to come. they may not sound that interrelated but i will tie them together at the end. bond market liquidity i will start with bond market liquidity. if you have read any financial market media over the past year, you would have been hardpressed to avoid reading an article on bond market liquidity. indeed, one of the best financial market commentators, matt levine, devotes a section of his column to “ people are worried about bond market liquidity ”. 1 notwithstanding the fact that his column is published daily, he has little problem in finding material to write about on this issue. so today, i would like to provide matt levine with some more material and throw my hat into this crowded ring. though not for the first time, as about a year ago i talked about this very issue. 2 so why revisit this issue again today? here are a few reasons : first, one year on, there have been a few noteworthy liquidity “ events ” in the bond market, including the awkwardly named “ flash rally ” in us treasuries on 15 october 2014, the day after i gave the speech last year. second, the much anticipated first increase in the fed funds rate has been designated as a critical test case of the state of liquidity in the bond market. third, while equity markets experienced a volatile month in august, bond markets were, somewhat surprisingly, relatively stable ( as for that matter, were major foreign exchange rates ). that serves to highlight the fact that liquidity and volatility are related but are not the same thing. so what exactly do i mean by bond market liquidity? generally i would take it to mean the ability to transact in the bond market without having a material influence on the price. for example, if i want to sell some of my holdings of australian government securities, how much will i be able to sell, and over

: / / www. bis. org / publ / cgfs52. htm >. michael lewis ’ s ‘ flash boys ’ brought high - frequency trading in equities into popular discourse. for the role of hfts in the foreign exchange market, see ‘ high - frequency trading in the foreign exchange market ’, markets committee publications no 5, september 2011. available at < http : / / www. bis. org / publ / mktc05. htm >. see joint staff report : the u. s. treasury market on october 15, 2014. available < http : / / www. treasury. gov / press - center / press - releases / documents / joint _ staff _ report _ treasury _ 10 – 15 – 2015. pdf >. at bis central bankers ’ speeches prices. so this event does not fit neatly into the category of a liquidity event. there was no prolonged dislocation where the price gapped rapidly and stayed there, which is often what people have in mind when thinking about the consequences of lower liquidity. nevertheless, the fact that such events can occur in arguably the most deep and liquid market in the world does mean that we need to understand what is going on here. as well as the impact of technology, regulation has also had a significant effect. regulatory changes have increased the cost to banks of intermediation, and hence liquidity provision, in many markets, and particularly the bond market. this has seen a number of participants withdraw completely and others scale back their activities. bond desks at banks hold less inventory than they have done historically, given the increased cost of doing so. this contributes to less “ depth of book ” liquidity, though not necessarily less “ top of book ” liquidity. the regulatory changes were intended to have this effect. liquidity provision was underpriced previously and was over - supplied. regulation has increased the cost of providing liquidity and hence decreased the quantity supplied. so the direction of change should not be the issue, rather the extent of the change should be the focus of debates about bond market liquidity. that is, has regulation increased the cost of liquidity provision too far with the result that liquidity in the bond market is now too low? that is certainly a discussion worth having. but in the meantime, liquidity in the bond market today is what it is. it continues to evolve but it is not going back to what it was any time soon.