LONDON: The calm on global financial markets masks a growing threat to their smooth functioning should shrinking liquidity morph into an outright crunch in response to a US interest rate rise or some other shock.

The price of German 10-year government bonds plunged this week, triggering the biggest rise in yield in over two years. Some analysts blamed the sell-off on a lack of liquidity, with Commerzbank going so far as to call it a “flash crash”.

There was no discernible market instability like a widening of bid/offer spreads, often a reliable sign of thinning liquidity. But there have been signs of potential dislocation in recent weeks — on one day in March the Bund bid-offer spread blew out to nearly 6 basis points, the widest in three years.

Analysis from GreySpark Partners shows that the average spread in high grade US corporate bonds since 2011 is around 12 basis points. In the five years before the global financial crisis, it was 7 basis points.

Liquidity is an amorphous concept and impossible to measure accurately. Its scarcity is only exposed in times of crisis. But everyone agrees it is shrinking, and this could dramatically push up the cost of trading, widen bid-ask spreads and make it harder for traders to close out positions.

As long as asset prices are rising, as most are thanks to super-easy global monetary policy, this isn’t a problem. But it will be if there is a sudden reversal and traders are forced to offload assets only to discover there are no buyers.

“This is a critical problem to the functioning of markets,” said Andy Hill, director of market practice and regulatory policy at the International Capital Market Association.

“Without secondary market liquidity, primary issuance will be impaired. We’re in a fragile state now,” he said, adding that lower rated corporate bonds, high yield debt and emerging markets are most vulnerable to a crunch.

The potential for a sudden freeze across a range of markets is a growing source of concern and debate among global policymakers and regulators.

They are trying to assess the impact on markets of regulatory changes that force banks to hold more capital and less inventory on their books. Financial market participants say this is curbing banks’ trading and their ability to act as market-makers in many fixed income, currency and money markets.

CARRY ON SHRINKING: There’s an important difference between the sea of liquidity worth trillions of dollars provided by global central banks in recent years and the dwindling liquidity as measured by market trading. In some ways, they are two sides of the same coin.

Published in Dawn, May 5th, 2015

On a mobile phone? Get the Dawn Mobile App: Apple Store | Google Play