There's Lots of Liquidity in Treasuries, Except When Needed Most

  • N.Y. Fed blog says trading affected at times of market stress
  • Liberty Street post cites market-structure change, competition

Sudden spikes of illiquidity have increased in the $12.8 trillion Treasury market, making it more challenging for investors trading government securities during times of stress, according to research from the Federal Reserve Bank of New York.

By most measures, Treasury-market liquidity has returned to precrisis levels, yet events such as the flash rally in Treasury yields on Oct. 15, 2014, seem to have become more common, according to research released Tuesday by New York Fed analysts. While liquidity -- or the ability to buy and sell debt without causing exaggerated price swings -- has stabilized, the potential for sudden bouts of illiquidity has increased and is best described as ‘liquidity risk,’” the research states.

That risk is likely due to changes in market structure, including the rise of electronic trading, rather than a common argument that it stems from heightened regulations on dealers, which has curtailed balance-sheet usage and market-making, researchers Tobias Adrian, Michael Fleming, Daniel Stackman and Erik Vogt wrote on the New York Fed’s Liberty Street Economics blog. Regulations from Basel III to the Dodd-Frank Act have caused banks to boost capital and reduce leverage.

"A growing share of liquidity provision in these markets is conducted by non-dealer entities like principal trading firms and hedge funds," the analysts wrote. While bid-ask spreads and other costs have decreased because of such competition, the changes "may have come at the cost of heightened liquidity risk, or sudden withdrawals of liquidity provision," they wrote.

Market Scrutiny

Trading in corporate debt, which is heavily intermediated by dealers and is even more balance-sheet intensive, hasn’t seen a rise in this liquidity risk, the authors added. That further confirms that more-frequent bouts of reduced liquidity in Treasuries stem from changes in market dynamics, such as electronic transactions occurring in high frequency, they wrote.

Dealer inventories dropped by 27 percent from 2007 to early 2015, while assets held by bond mutual funds and exchange-traded funds almost doubled, according to data from Bloomberg, the New York Fed and the Investment Company Institute.

Bank executives have warned about liquidity. Jamie Dimon, chief executive officer of JPMorgan Chase & Co. said this year that the Oct. 15 swing was a “warning shot.”

The increase in sporadic drops in liquidity in recent years has been mirrored by more spikes in the degree of volatility, known as the volatility of volatility, or the vol-of-vol. The number of jumps in the vol-of-vol in an 18-month trailing basis has increased and has been mirrored by a similar drift higher in liquidity risk, the N.Y. Fed research indicated.

Federal Reserve Bank of New York

“Our findings suggest a trade-off between liquidity levels and liquidity risk: while equity and Treasury markets have been highly liquid in recent years, liquidity risk appears elevated,” the N.Y. Fed blog post said.. “This change has gone hand-in-hand with an apparent increase in the vol-of-vol of asset prices, so that illiquidity spikes seem to coincide with volatility spikes.”

In the corporate bond market, liquidity risk had actually declined in recent years, the researchers wrote. “While some market commentators are concerned about a decrease in liquidity, or perhaps an increase in liquidity risk in credit markets, we are not able to detect such changes,” they said.

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