Structural Aspects of Market Liquidity from a Financial Stability Perspective - A discussion note prepared by the CGFS for the March 2001 meeting of the Financial Stability Forum (FSF)

Introduction and overview

At its September 2000 meeting, the Financial Stability Forum (FSF) invited the Committee on the Global Financial System (CGFS) to consider whether recent structural changes had adversely affected the liquidity of financial markets. To help prepare the CGFS's response to this, the Bank of England hosted a meeting of CGFS representatives and senior managers of about a dozen global financial firms in London on 14 December 2000. The meeting was chaired by Ian Plenderleith. At this meeting, senior private sector managers, many of whom with direct management responsibility for their firms' trading activities, were asked to set out their views as to whether liquidity conditions had recently changed in the core financial markets and, if so, what had been the factors behind the change. This note incorporates the results of this discussion. In addition, it draws on earlier work by the CGFS, other BIS groupings and submissions by central banks. A background paper prepared for the September 2000 CGFS meeting examined some commonly used indicators of market liquidity. This is reproduced as an annex to this note.

Liquidity is difficult to define and even more difficult to measure. Of the several dimensions of market liquidity, two of the most important are tightness and depth. Tightness is a market's ability to match supply and demand at low cost (measured by bid-ask spreads), while market depth relates to the ability of a market to absorb large trade flows without a significant impact on prices (approximated by volumes, quote sizes, on-the-run/off-the-run spreads and volatilities). When they raise concerns about the decline in market liquidity, market participants typically refer to a reduced ability to deal without having prices move against them, that is, about reduced market depth.

According to market commentary, liquidity in many markets never fully recovered from the sharp deterioration experienced during the 1998 financial crisis. However, market participants at the London meeting nevertheless expressed the view that liquidity conditions were, at the current juncture, not a cause of acute concern. Moreover, it was acknowledged that cycles in liquidity conditions have been a recurring feature of financial markets.

Commonly used indicators of market liquidity, although being notoriously imperfect measures of liquidity conditions, also suggest a rather benign picture. While the autumn of 1998 is indeed identified as an adverse shock to the liquidity of financial markets, liquidity indicators seem to suggest that, with the notable exception of the US government bond market, liquidity conditions have been broadly restored to pre-crisis levels. However, the usual indicators typically capture only a single dimension of market liquidity and none of them is forward looking in nature, making it difficult to draw any conclusions as to what liquidity conditions might be in times of future stress.

While idiosyncratic factors might be cited as being responsible for the perception of low liquidity in specific markets, reduced liquidity is unlikely to be a purely conjunctural phenomenon. This note sets out to highlight, from a financial stability perspective, some of the structural factors at work. In doing so, it focuses on developments bearing on liquidity conditions at three different levels, namely:

(i) Firms : developments at the level of the main financial firms participating in the core financial markets;

(ii) Markets : developments in the structure and functioning of markets themselves; and

(iii) System : developments across the global financial system as a whole.

This note illustrates how such structural developments may have served to reinforce the links between liquidity and credit risks, but also the distinction between normal times and times of stress. Discussions with market participants have revealed few concerns about liquidity problems under present market conditions. It was felt that liquidity pre-LTCM in many markets was underpriced, and that this led financial institutions to underestimate liquidity risks ("liquidity illusion"). One participant argued that such underpricing inhibited developments that would enhance the market's ability to retain liquidity in times of stress. There have indeed been several occasions since the LTCM crisis when conditions in some markets turned adverse but liquidity, which typically declined sharply in the midst of the crisis, proved to be rather resilient.

However, some elements of recent developments might influence the behaviour of market participants in a way suggesting that market dynamics in times of extreme stress may have changed significantly. Financial consolidation, the increasing use of non-government securities as hedging and valuation benchmarks, and other developments may have heightened concerns about credit risk. Such concerns can undermine market participants' willingness to enter into transactions and thus weaken market liquidity in a more uncertain environment. Other elements, such as collateralisation practices and developments in risk management policies, which should generally enhance market stability, could add pressure in times of extreme stress.