The resolution of the financial markets will be tested again and again in the years to come. To ensure that confidence remains high and growth is sustained, it is vital that those within the industry fully understand the changes that have happened since the onset of the financial crisis, writes Bank of England deputy governor Minouche Shafik.
The episodes of volatility in financial markets that we have seen over the past year or so have thus far been relatively short-lived. This is true of the flash rally in US Treasury markets, the tantrum in German bund markets, the surge in the Swiss franc, and the importing of equity market turbulence from China. In each case, governments, banks and businesses regained access to markets after only temporary interruptions and continued to raise the capital they need to drive economic growth.
But the coming years will likely provide bigger tests of the resilience of financial markets. Three of the forces that have been dominant since the financial crisis – accommodative monetary policy, private sector inflows to emerging markets, and official sector outflows in the opposite direction – seem set to change. If those 'tectonic shifts' trigger a broader rush for the exit in widely held positions, there is a risk that a prolonged period of volatility could trigger a severe reduction in market liquidity and ultimately a loss of confidence in the ability of markets to contribute to sustainable growth.
To ensure this does not happen, it is vital to understand the dramatic changes that have taken place to market structures since the financial crisis. Banks’ ability and willingness to put capital at risk in order to make markets has reduced, while electronification has facilitated a rapid increase in the market share of firms who hold positions for only brief periods on the basis of automated trading strategies. At the same time, the ecosystem of markets has become more diverse as the range of platforms over which trades can take place has increased.
Changing landscapes
Regulation is undoubtedly one factor driving these changes. Indeed, the desired outcome of raising capital and liquidity requirements was that banks would think more carefully before extending their balance sheets. But it is not the only factor. Much of the reduction in balance sheet at market-making banks actually preceded the design or implementation of post-crisis regulatory reform, suggesting that banks’ own realisations of the risks that were implicitly being run would have changed the level of liquidity they were willing to provide even in the absence of regulation.
Moreover, the changes we are witnessing may also be a natural result of evolution and innovation. Market making would not be the first industry to change dramatically to gain efficiency: just-in-time management swept through manufacturing in the 1970s and 1980s with its focus on minimising waste, eliminating inventories and quickly responding to changing market demand. More recently, supermarkets have reversed their once relentless expansion of retail space, and started moving away from inventory-intensive hypermarkets toward smaller retail units.
What do all of these changes imply for market liquidity? The continued decline in bid offer spreads would suggest that for some markets at least the reduction in liquidity offered by market-making banks has been more than offset by the increase in liquidity provided by other participants and venues. But the episodes of illiquidity in the past year or so suggest that although liquidity may on average be higher, the risk that liquidity may not be available when it is needed most has also risen.
Reducing risk
Policy-makers can take steps to reduce this risk. Where unintended consequences of regulation can be reduced without jeopardising hard-won improvements in the safety of the system, we should be willing to do so. And as the structure of financial markets continues to evolve, it will be important to ensure that the use of stabilising mechanisms – such as circuit breakers on exchanges and liquidity management tools in investment funds – are regularly reviewed.
Ultimately, however, much of the responsibility for adapting to changes in market structure lies with those who determine prices – i.e. market participants. Issuers should consider whether changing market structures warrant a re-examination of the merits of standardisation in order to promote secondary market liquidity. And investors must ensure that their investment horizon is aligned with the inherent liquidity of that asset. I am reminded of the old adage 'caveat emptor'. When it comes to matters of market liquidity, 'let the buyer beware' remains good advice.
Minouche Shafik is deputy governor of the Bank of England.
