Last week Mark Carney revealed an extraordinary statistic. According to the governor of the Bank of England, it now takes seven times as long for investors to liquidate bond portfolios as in 2008.
The reason? Eight years ago investment banks and brokers held such large inventories of bonds and other assets that they were happy to act as market makers, standing ready to buy or sell when investors wanted to trade. But, since the crisis, banks have slashed these inventories by about 70pc because of tighter regulations and a new climate of risk aversion. They have also cut the size of bond deals. This makes it much harder for sellers of bonds to find buyers, particularly if everyone wants to sell at the same time.
The ‘exits’ for trades, to use banking jargon, are crowded. And that means that while the markets might seem placid today, particularly given the easing announced by the Japanese and European central banks, this calm could come to a halt if investors try to sell en masse.
“Fundamentally, liquidity has become more scarce,” Mr Carney says. This seems to have sparked some bizarre price swings, such as the so-called ‘flash crash’ in the Treasuries market last month.
The big question is what will happen when the US Federal Reserve starts raising rates. If investors rush to sell US government bonds, that will create one seriously crowded exit.
There are many other potential flashpoints, particularly in markets where trading has traditionally been much thinner than in Treasuries.
Emerging market corporate bonds are a case in point: the level of corporate borrowing has jumped sharply, particularly in Asia, which might prompt investors to flee. The bonds issued by shale gas developers are another potential flash point; the tumble in oil prices has put this sector under pressure.
Is there a solution? Behind the scenes, there is plenty of brainstorming. For now regulators seem opposed to the step bankers most want: a relaxation of reforms such as the international Basel III regulations or America’s Dodd-Frank act. Instead, as a paper released last week by the Bank for International Settlements spells out, they are focusing on other measures they hope could ameliorate liquidity risk. They are pushing for more transparency and standardisation in bond markets, and for more activity to take place on electronic exchanges, which can make trading easier.
Some countries are considering measures to support secondary markets in their sovereign bonds (say, encouraging asset managers to lend more bonds to each other). Regulators are also urging financial companies to create more buffers to help them survive if markets freeze up. Some are listening.
BlackRock, the world’s biggest asset manager, has taken the unusual step of issuing a public paper on the matter, arguing that some of the regulators’ concerns are overblown, since the company and its peers are well aware of the problems and ‘fund managers have several tools to manage liquidity risk’.
Still, it would be an exceptionally bold trader who would bet that such measures can remove the potential for shocks, given the scale of liquidity shifts.
And that has two important implications for central banks. First, it suggests economists will need to pay attention to the changing nature of finance when they assess in coming months how their monetary policy will play out.
That point might sound obvious. But as Kevin Warsh, a former Fed governor, pointed out last week, the central bank’s economic model still does not take account either of the world beyond the US or the vagaries of finance. It blandly assumes financial markets are stable. That turned out to be wrong in 2008, and it could be even more misguided in the year ahead.
Second, these trends imply that central banks may need to reassess their own role in the bond markets, too. Ever since the days of Walter Bagehot, the 19th century British economist, central banks have accepted t hat one of their roles is to lend freely to solvent institutions in a crisis. But they have generally shied away from acting as market makers or from rescuing non-banks. “Backstopping market liquidity directly risks structurally distorting economic incentives,” the BIS paper notes.
But the 2008 crisis and its aftermath have forced central banks to break many taboos. If a bond crisis erupts, this one may crumble too, forcing central banks to jump in.
As Mr Carney observed in Singapore: “Bagehot will need to be updated for the 21st century.” Watch this policy space, and that sevenfold statistic.
Published in Dawn, Economic & Business, December 1st , 2014