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. This primer provides an introduction to the issues by addressing the following questions.
- What is market liquidity?
- Why do we care about it?
- Has it actually declined?
- What do the recent bouts of market volatility mean?
- Why would we expect market liquidity to be down?
- Will market liquidity decline further?
- What factors might offset tightening liquidity?
- What should be changed to improve market liquidity?
Overview and recommendations
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 help 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 and evaporated quickly under stress. 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. There appears to have been a decline in underlying liquidity in the markets and this seems highly likely to worsen to some extent. There are numerous factors at work, including the evolution of the structure of financial markets and the effects of unusual economic conditions, especially extremely loose monetary policies and massive direct central bank purchases of bonds. I also believe we 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. Unfortunately, this cost-benefit analysis is complex and still subjective at this point, in part because so much of what is happening to liquidity remains ambiguous and the largest effects are likely to be in the future.
Whatever the overall conclusions about regulation, it is clear that the cumulative effects of a series of regulations have made it 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 similar firms will pick up some of the slack as the large dealers pull back, 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 at least four 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. On the other hand, there are a number of indicators, such as average bid/ask spread, that do not show signs of a less liquid market, so while there appears to have been an overall decrease in liquidity, the evidence is ambiguous.
Thus, the effects we have seen already are not deeply worrisome on their own. The bigger issue is the probability that market liquidity will considerably worsen going forward. First, the very loose monetary policies of central banks around the world appear 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.
In sum, there are good reasons to worry about market liquidity and to believe that policymakers may have unintentionally overshot. However, the disaster scenarios that some suggest do not seem plausible, nor does any regulatory overshoot mean 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. At this point, the key is to revisit the various key regulations and to seriously review the costs and benefits of the choices that were made about the details.