Global Financial System Committee Provides Analysis of Liquidity in the Fixed Income Market

The Committee on the Global Financial System (“CGFS”) provided a detailed analysis on the current state of liquidity in the fixed income market. Published by the Bank for International Settlements (“BIS”), the report acknowledges that liquidity has declined in some markets, but observed that this decline has been primarily reflected in the size of trades rather than in a widening of the bid-ask spread.

The report states that the demand for market-making liquidity (which the report refers to as “immediacy”) increased, while dealers continue to reduce their willingness to take on customer positions, either because they find it unprofitable to do so or because new regulatory capital requirements make it impossible for them to do so.

The report identifies a potential trade-off between increased capital requirements for market makers, which according to the report, makes them more resilient, and the expense of maintaining such capital, which makes market makers more reluctant to take on risk. Further, the report states that very high capital requirements may actually make the system less resilient; i.e., “fragile,” because any decline in market prices can very quickly force deleveraging, which, if it becomes widespread, results in market sell-off.

Lofchie Comment: This report is a significant step forward by the global regulators in at last acknowledging that very high and potentially punitive capital requirements may be counterproductive and a source of risk. This may seem counterintuitive. It may appear obvious that when a single institution has more capital than others, it is better placed to survive a downturn than are others. However, when all institutions carry more capital, because they are all subject to higher capital requirements, a new risk arises because there is no cushion between the amount of capital an institution must have and the amount it actually has. Further, the “punishment” (being forced to shut down) for a capital violation is severe. Accordingly, universally high capital requirements combined with severe sanctions for capital failure is likely to lead to the result that in a downturn, everyone is very fast to flee the market; i.e., the system then becomes more “fragile.”

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