by Chris Black
Investors take for granted that securities dealers will exchange cash for financial assets on demand, but that expectation can only be met in benign conditions.
The on-going deluge of debt securities impacts interest rates, but also makes liquidity relatively scarce as private sector buying power is limited while debt issuance is, at least in theory, not.
While Treasuries remain the safest and most liquid security in the world, they are structurally becoming less liquid.
The average daily cash transactions in Treasuries has not come close to scaling with the overall growth in issuance.
Although average daily cash volumes (www.sifma.org/wp-content/uploads/2023/04/SIFMA-Research-Quarterly-Fixed-Income-Issuance-and-Trading-2Q23.pdf) have increased slightly in recent years to $715b, that increase is in part due to the activity of principal trading firms (www.federalreserve.gov/econres/notes/feds-notes/principal-trading-firm-activity-in-treasury-cash-markets-20200804.html) whose strategy is to profit from small intraday price arbitrage.
These firms account for 20% of cash market volumes (www.federalreserve.gov/econres/notes/feds-notes/principal-trading-firm-activity-in-treasury-cash-markets-20200804.html), but they disappear when volatility picks up (www.newyorkfed.org/newsevents/speeches/2020/log201023) so their provision of liquidity is illusory.
Excluding their participation, cash market activity would be progressively declining relative to the steady growth in debt issuance.
This means the Treasury market – the largest and most systemically important in the world – is not liquid relative to potential investor activity, and explains why it becomes fragile at even minor external shocks.
Daily cash transactions volumes for other major asset classes have also not scaled with overall issuance.
An era of low interest rates led to a rapid growth in debt as companies and households borrowed heavily.
While liquidity in Agency MBS is just slightly worse than Treasuries, corporate bond market liquidity is very low.
There are over $10 trillion in outstanding corporate bonds, but daily cash volumes are around $30b. It would be difficult to liquidate large amounts of corporate bonds in typical market conditions, and next to impossible during times of immediate market stress.
This was seen in March 2020 (www.federalreserve.gov/econres/notes/feds-notes/the-corporate-bond-market-crises-and-the-government-response-20201007.html) and the corporate bond universe has only gotten bigger since.
One major reason for the poor liquidity is the declining warehousing capacity of securities dealers, who are the primary providers of liquidity to the market.
When an investor wants to sell a debt security he calls a dealer, who offers to takes the security in exchange for cash.
The dealer holds the security on his balance sheet as inventory until he is able to off load it to another client at a slightly higher price.
Total dealer assets, a rough measure of their overall capacity to warehouse securities, has slightly risen over the past few years but remains clearly below 2007 levels.
At the same time, the universe of debt securities has exploded higher due to elevated deficit spending and an era of low interest rates. This suggests the potential demand for liquidity is increasing significantly relative to the potential supply.
The decline of dealer warehousing capacity is both structural and by regulatory design.
Similar to the banking sector, the number of broker-dealers has steadily declined over past decade, potentially due to industry consolidation, competition, and rising regulatory requirements (news.law.fordham.edu/jcfl/2020/09/26/the-broker-dealer-profession-is-trending-down-no-the-answer-to-why-is-not-covid/).
A decline in dealers from 5000 to 3000 mechanically implies less potential capacity to warehouse securities.
Basel III regulations enacted post-GFC also negatively impacted warehousing capacity by increasing the regulatory costs of holding securities.
This successfully protected dealers from loading up on too much risk and blowing up, but also made the markets themselves much more fragile.
The newly announced Basel III Endgame rules are expected to “substantially” increase the capital requirements (www.federalreserve.gov/aboutthefed/boardmeetings/gsib-memo-20230727.pdf) of trading activity for some bank affiliated dealers and may further disincentivize dealer businesses.
While many proposals have been made to improve Treasury market liquidity , none are meaningful solutions.
The bottleneck for market liquidity is not so much dealer intermediation capacity, but the lack of end investors (buyers) in times of volatility and market stress.
While proposed structural changes can disintermediate (www.newyorkfed.org/medialibrary/media/research/staff_reports/sr1036.pdf) (reduce the market’s reliance on) dealers or increase their trading capacity (www.newyorkfed.org/research/staff_reports/sr964), at the end of the day there must be an investor willing to hold the sold securities in exchange for cash.
Dealers are willing to do so because they can manage the risk and easily finance the purchases (libertystreeteconomics.newyorkfed.org/2022/01/the-feds-latest-tool-a-standing-repo-facility/).
If there were enough end investors in March 2020, then the dealers would have just off-loaded securities and there would not have been liquidity issues.
But at that time there were no end investors, dealer warehousing capacity was maxed out, and the Fed stepped in (www.newyorkfed.org/medialibrary/media/research/staff_reports/sr998.pdf) as an end investor of last resort.
The market structure has not improved since then, so that episode will repeat.
Whether it is exposed precipitously in the form of a crisis (COVID-19) or progressively over time is unknown, but these things tend to build slowly and then capitulate all at once.
The end investor of last resort will again be a Fed role, and this time it may be continuous (www.stlouisfed.org/on-the-economy/2020/august/what-yield-curve-control).
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