Market liquidity is one of those luxuries that you fully appreciate only when they are gone. Did we ever know or appreciate the luxury of transacting hundreds of millions of dollars (or Pounds or Euros) of benchmark Government bonds in a single ‘clip’ on the quoted price – or better? Now the story goes that you be lucky to transact $50m on the same basis in the largest Govvy markets. Don’t even ask about liquidity in Corporate Bonds; most buyside analysts will tell you that it too has drastically reduced. The new shallowness of these markets is often concealed by the appearance of narrow bid-offer spreads and these in turn reflect the competitive environment rather than any real market depth. Corporate bond markets do stand out as extreme evidence of diminished market liquidity, both in the USA but more so in Europe. Market participants report that volumes in European corporate bond markets have declined by almost 50% in the past 5 years. Block or portfolio trades routinely need to be split into smaller tickets to avoid moving market prices. The electronic platforms now accept only the dwindling number of names which will attract activity and liquidity.
Most would put the blame for all of this at the door of regulators. Granted, the architects of Basel Ill, MiFID II, Dodd-Frank were more concerned with preventing another financial crisis as devastatingly costly as 2008 than with preserving market liquidity. However, it seems unlikely that legislators and regulators will have fully thought through the fiscal and economic implications. Efficient and liquid bond markets, when they were that, kept down the cost of Government borrowing. They are also a vital source of corporate funding in the USA and had been steadily growing in importance here in Europe. Liquidity in European corporate bond markets had been growing but no longer and this will cut off on important source of funding for many corporates just when their alternative source, banks, are being forced to deleverage. So regulation requiring financial institutions to hold substantially higher levels of capital and to maintain ready access to stable liquidity has greatly reduced the liquidity available to Governments and corporates.
This has largely happened because the banks and investment banks, in their roles as market-makers and primary dealers have smaller risk appetites with which to provide liquidity to borrowers and investors in the bond markets. US data shows that since 2008, dealer inventories of US corporate bonds have declined by over 60%.
Fragmentation of European markets in the context of a hard fought and politicised Brexit would be a serious concern in any environment but most especially so in the circumstances described above. This could happen if, for example, Eurozone Government bond trading were required to take place within gthe Eurozone, even though it is far from obvious how that could be implemented or enforced.
The fault lines in the Eurozone banking sector go way beyond those illustrated by the recent difficulties at Monte Dei Paschi Di Siena or at Deutsche Bank. Banks in the Eurozone have such a weight of non-performing loans that the European Banking Authority (EBA) recently said that dealing with so-called NPLs was "urgent and actionable". Banking systems across the Eurozone have been trying to deleverage their balance sheets since the Eurozone crisis erupted in 2011. The unsurprising reluctance of banks to extend credit in these circumstances has been felt acutely by Corporate borrowers, especially those that are sub-investment grade. These are exactly the circumstances when enhanced bond market liquidity would be most appreciated. The risks to economic growth and reduction of EU unemployment are obvious.
The likely beneficiary from these (disastrous) circumstances would be the well-established and less politically contentious markets of New York City. Nowhere in the EU other than London comes close to offering the economies of scale, the skills and market depth. New York could rapidly replace London, or at least far faster than Frankfurt or Paris.
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