Itay Goldstein
The events in corporate bond markets in the US in March and April of 2020, as the Covid-19 crisis erupted and threatened the world economy, exposed key fragilities from the liquidity transformation that is performed in these markets. Now, a year later, the debate is still raging about the takeaways from these events and the need for future reforms.
One of the key functions of financial intermediation is the transformation of liquidity. Financial intermediaries hold illiquid assets, but allow their investors access to ample liquidity, as they can withdraw their money at short notice. Traditionally, this role was performed mostly by banks, which finance long-term illiquid loans with deposits. Over the years, other market intermediaries stepped in to perform a similar role.
This tendency has strengthened after the global financial crisis of 2009. Restrictions imposed on banks made it more difficult for them to perform the same level of liquidity transformation. The gap has been filled to some extent with market-based intermediaries operating in corporate bond markets, such as open-end mutual funds. They increasingly hold illiquid assets, while still allowing their investors redemptions on a daily basis.
While quick intervention by the Fed likely averted a much more serious crisis, solely relying on such interventions should not be the goal
Such liquidity transformation can be beneficial on many levels, but it also opens the door for financial fragility. This is well known from banks: expecting that other depositors will take their money out, each depositor wants to do the same, creating mass withdrawals out of a self-fulfilling belief. This is called a bank run. In recent years, concerns have been raised that liquidity transformation by mutual funds in corporate bond markets exposes them to similar forces. The events last March showed how forceful such dynamics can be. Open-end mutual funds saw record outflows, and the outflows were most severe in those that were more fragile according to previously identified parameters, such as the illiquidity of the underlying assets.
Now, some observers claim that as in the end no major crisis happened, the events prove the opposite, and that fragility is not as bad as feared. But, such accounts of the crisis are partial and misleading. A major crisis was averted to a large extent because of the swift intervention of the US Federal Reserve.
As outflows were intensifying in March 2020, and yields on corporate bonds skyrocketed, the Fed not only unleashed the whole playbook of the 2009 crisis at a much faster pace, but went beyond that in announcing steps that were not taken before and were directed at the corporate bond market. Specifically, via the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF), it announced on March 23 that it was ready to buy up to $300bn of corporate bonds. It then extended that to $850bn on April 9, which finally reversed the pattern of outflows.
Alleviating underlying fragilities
So, looking back today, the lesson should not be that the sector is resilient, but rather that it is fragile. While quick intervention by the Fed likely averted a much more serious crisis, solely relying on such interventions should not be the goal, and steps should be considered to alleviate the underlying fragilities. A few directions for action can be considered.
First, one way to reduce the gap between the illiquidity of the assets and the liquidity offered to investors is to attempt to improve the liquidity in corporate bond markets. Corporate bond markets are notoriously illiquid, unlike their equity counterpart. Trade still happens in a decentralised way and assets can go days without being traded. There have been discussions over the years about bringing corporate bond markets into the 21st century and improving their liquidity. In light of the exposed fragilities, such reforms appear even more important.
Second, another way to shrink the gap is to offer less liquidity to investors. The tendency to offer liquidity to investors is amplified by competition among investment funds, but clearer requirements for fragility-reducing steps can overcome this. One such step is to introduce the swing pricing feature, whereby investors are penalised when taking money out of the fund at a time when many other investors do so. This acts to reduce the effective liquidity investors enjoy and reduces fragility. Swing pricing was introduced as a possibility in the US in 2018, but has not been adopted by funds prior to the events of last year. There is evidence from other countries that it is an effective tool.
Third, if we go further with the transition where funds perform the roles of banks and rely on the government for liquidity provision, it would be appropriate to level the regulatory playing field. After all, banks face more restrictions with respect to their portfolios and also pay for some of the liquidity they know to expect.
Itay Goldstein is professor of finance at the Wharton School of the University of Pennsylvania.
