BoE calls for investigation into market liquidity risks

The Bank of England's (BoE) Financial Policy Committee (FPC) today called for an investigation into the dangers posed by sudden drops in market liquidity, warning some investors appear poorly prepared.

"The committee remains concerned about the risk that market liquidity could prove fragile in stressed conditions, and judges that there is a need for market participants to be aware of these risks," governor Mark Carney wrote to the UK's chancellor.

As such, the BoE and the Financial Conduct Authority (FCA) plan to gather information from UK asset managers on their liquidity management during both stressed and normal times. The BoE also plans to conduct research into the impact of structural changes on market liquidity.

Questions remain unanswered about extreme volatility and a sharp drop in liquidity in the US Treasuries market on October 15 last year, which saw yields move more than seven standard deviations from their normal levels.

The shock alerted regulators to the threat that even the most liquid markets can suddenly dry up. The BoE's executive director for markets, Chris Salmon, told a Central Banking conference earlier this month that markets "may not have been truly tested" for their ability to cope with more persistent shocks.

The BoE and FCA will work on identifying data gaps, deepening their understanding of the channels through which the UK could be affected by market corrections, and assess how and why markets may have become more fragile.

Salmon theorised the growing predominance of electronic trading platforms likely had a hand in October's crash. While the platforms help pool liquidity in calmer times, they tend to automatically shut down at the first sign of trouble, impairing liquidity.

The FPC asked for a preliminary report for its next meeting in June and a final report in September.

Paradox of buffers

Research published by the Bank for International Settlements (BIS) this week sheds more light on the issue. Author Enisse Kharroubi identifies a mechanism through which markets may end up rationally reducing their liquidity buffers to zero.

"In this model, the economy paradoxically runs short of liquidity because funding is abundant, not because it suddenly becomes very scarce," Kharroubi writes.

In the working paper's model, agents can either hold liquidity in reserve, or seek additional funding as and when needed. Liquidity buffers become more appealing when funding is costly. The buffers enhance a firm's safety, making future income more pledgeable and therefore lowering funding costs.

Where funding costs are high – low market liquidity – firms have an incentive to build buffers. The demand for funds pushes up the cost of funding and therefore makes building buffers more appealing. The economy tends towards a well-protected equilibrium.

But where funding costs are low – high market liquidity, such as the US Treasuries market – firms tend towards a second equilibrium where they build no buffer at all.

"This externality is more likely to hold when there is large exogenous funding supply and/or aggregate shocks display low volatility," Kharroubi says.