OFR Publishes Working Paper on Liquidity Dynamics During Crises

The Office of Financial Research (“OFR”) published a working paper, “An Agent-based Model for Crisis Liquidity Dynamics,” that examines the effect of financial crises on (i) the balance sheets of market makers and their ability to take on inventory; and (ii) the difference in time frames between liquidity demanders and liquidity suppliers.

In order to “successfully model the dynamics of liquidity during market crises,” the authors of the working paper claim that it is important to understand demander and supplier (i) decision cycles, (ii) market dislocation; and (iii) stress to their portfolio adjustments. As to market makers, the authors state it is important to understand: (i) their capacity for taking on inventory; (ii) how long are they willing to hold these positions; (iii) the cycle of feedback for how these are affected by the market dislocations; and (iv) how they in turn further affect funding, leverage, and balance sheets.

The authors recommended that policymakers combat illiquidity by:

  • reducing the speed and size of liquidity demand, which has “taken the form of circuit breakers or a slowing of the cycle of margin calls”;
  • increasing the capacity and holding period of the market makers through infusions of funding, which (i) allows the broker-dealers to apply a larger balance sheet in their marketing activities; (ii) reduces the pressure on leveraged investors, which is “possibly stemming mushrooming liquidity demand;” and (iii) adds more funding for liquidity suppliers to enter and take larger positions; and
  • increasing the speed and size of the liquidity suppliers, which “has taken the form of government policy to step in as a liquidity supplier of last resort buying up assets when ready liquidity supply from the marketplace is flagging.”

The authors concluded that liquidity is “intricately linked” to the funding and capital structure of the markets. The authors cautioned that projecting the course of liquidity during a crisis without taking into account the real-time specifics of leverage, balance sheet, portfolio construction and decision process is “likely to fail”.

Lofchie Comment: Increased capital requirements on dealers, combined with the prohibition on bank dealers taking material positions, should significantly increase market volatility because market makers are much less likely, and are less able, to dampen such volatility. In fact, with a system of strict capital regulation, one should expect to see market makers very quickly being forced to liquidate into declining markets.

To counter the possibility of a market crash, the report suggests increasing the speed and size of liquidity suppliers – but actually, it is apparent that government policy is largely going in the opposite direction.

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