US financial markets are critical to the functioning of our entire economy, providing more credit, for example, than banks do. Our unusually large financial markets have been an American competitive advantage for years, providing a cost-effective means of matching investors with worthy companies and projects. Therefore, the current debate about whether market liquidity is drying up is an important one, since the ability to buy and sell securities is central to market functioning.
The short answer is that I believe we need to recalibrate a series of financial regulations, because there is a real risk that we have damaged underlying market liquidity, although I do not subscribe to the doomsday scenarios where this produces a financial crisis. Nor do I think we need to radically overhaul the regulations. I use the term “recalibrate” advisedly, to suggest technical corrections, not a wholesale abandonment of broadly sensible reforms. This is a complex topic; I will soon be issuing a much longer report on market liquidity and will therefore only provide a summary here.
Market liquidity refers to the ability of buyers and sellers of securities to transact efficiently and is measured by the speed with which large purchases and sales can be executed and the transaction costs incurred in doing so. These costs include both the explicit commission or bid/ask spread and the, often larger, loss from moving the market price by the act of making the bid or offer for a large block. This latter effect ties market liquidity to price volatility, as transaction volumes lead to bigger price movements when markets are illiquid.
We care about market liquidity because it affects the returns for investors, such as those saving for retirement or college, and the costs to corporations, governments, and other borrowers. Further, illiquid markets are more volatile. At the extreme, volatility can trigger or exacerbate financial crises. Even the average level of volatility matters, as it is factored into the interest rates demanded by investors and paid by borrowers.
Market liquidity is a complicated issue in part because it is not clear what is happening to underlying liquidity. Pretty much everyone agrees that markets are less liquid than they were in the run-up to the financial crisis, but it is not clear that this is a problem, since those liquidity levels were unsustainable. The harder parts are to compare liquidity to an optimal sustainable level and to project liquidity into the future. There is no agreement on either the optimum level or the future course of market liquidity.
Despite the uncertainties, policymakers are right to take this issue seriously and to worry about the risks. We appear to have overshot in our regulations in a way that will cramp market liquidity excessively, producing more social costs than the benefits of greater financial stability. To be clear, most of what has been done is positive; it is a matter of recalibrating the details to reduce the social costs while keeping the core benefits.
Why do I think it likely that we have overshot? The cumulative effects of a series of regulations have made it substantially more difficult and expensive for banks and large securities dealers to act as market makers. (These rules include the liquidity coverage ratio, the net stable funding ratio, the supplementary leverage ratio, various changes to the capital rules under the Basel capital accords, the Volcker Rule, and others.) Smaller dealers, hedge funds, and other asset managers will pick up some of the slack, but there are real limitations on their ability to do so cost-effectively. The markets can also adapt, such as by moving to agency rather than principal models and by embracing electronic markets, but, again, there are some serious limits on how far these moves can go.
The net result should logically be decreased liquidity and we have already seen much lower securities inventories held for market-making purposes by dealers along with some other signs of lessened liquidity. There have also been four or five incidents in the last couple of years in which markets showed extreme volatility that may have been exaggerated by lower liquidity, such as the “taper tantrum” in the bond markets. It is difficult to know if these are isolated incidents or the tip of a dangerous iceberg.
If all we had to worry about was what we have seen already, then I would not be worried very much. My concerns stem from the probability that market liquidity will get considerably worse going forward. First, the very loose monetary policy of central banks around the world appears to have provided considerable support for market liquidity while also holding down price volatility. When monetary policies eventually tighten, market liquidity is likely to be more of a problem. Second, banks and large dealers are almost certain to cut back further on their liquidity provision and to raise their prices over the next couple of years. Many of the rules that increase their costs are only now being finalized or are being phased in over time. Further, dealers know they will lose customers if they make one big move, rather than spreading the pain over multiple years, especially if their competitors take smaller steps. I have seen it in other financial cycles; these adjustments get spread over time, so there should be more to come.
In sum, there are good reasons to worry about market liquidity and to believe that policymakers have unintentionally overshot. However, I do not subscribe to the disaster scenarios that some suggest, nor do I think the overshooting means that we have to redo financial reform in major ways. This is a matter of taking the issue seriously and recalibrating a series of technical measures to reduce the damage to market liquidity without increasing the risks to financial stability in any significant way.