Neither liquid nor solid
Where the next financial crisis may appear
Jul 12th 2014
WILL liquidity be the cause of the next great financial crisis? Recent problems in the obscure-sounding, but highly important, repo market may hint at the trouble to come.
A repo, or repurchase agreement, is a short-term loan. One party sells a security to another, in return for cash, and agrees to buy it back at a later date for a higher price. The difference between the two prices is equivalent to an interest payment. The security, which is usually short-term Treasury debt, acts as collateral for the loan.
Repos are the oil that greases the wheels of the financial system, allowing financial institutions to manage their cash needs. Global repo turnover is estimated at $1.6 trillion every day. In recent weeks, however, there has been a sudden surge in “fails”—trades in which parties to a repo agreement have been unable to deliver the required security (see chart).
Past spikes in the fail rate have been associated with periods of market nervousness (such as Congress’s tardiness in increasing the debt ceiling in 2011). But this time the markets are fairly calm.
The current problem seems instead to be linked to regulation. After the crisis of 2007-08, when banks struggled to get funding in the money market, financial regulators have focused not just on banks’ capital, but also on their liquidity. Two particular regulations—the net stable funding ratio and the supplementary leverage ratio—seem to be discouraging banks from taking part in repos, by making it more expensive for them to own short-term debt.
Why does this lead to failed trades? Not all Treasury securities are equal; some are more attractive for repo financing than others. With less liquidity in the market, those desirable Treasuries can be hard to find: some short-term debt can trade on a negative yield because they are so sought after. If dealers cannot get hold of the right security, the trade fails.
No one is suggesting that the repo market is about to collapse; those who use the market may simply find that short-term funding becomes more expensive. But the problem is much wider. A number of banks have found that making money in fixed-income dealing is a lot harder than it used to be, not just because of regulations but because of declining trading volumes and low volatility.
They have accordingly reduced their activity in the area, cutting back staff and reducing the capital they devote to the market. This has resulted in an even greater drop in trading volumes.
“Thin secondary markets suppress volatility today, but will likely amplify it later,” says Bhanu Baweja, a strategist at UBS, a Swiss bank. Turnover in the American high-yield bond markets is less than half what it was in 2007, although issuance has continued to be high and investors have been piling into the market in search of higher yields.
The popularity of corporate debt with investors means that the liquidity problem tends to be overlooked. Indeed, poor liquidity helps to boost asset prices in a boom (as it does with houses in central London), with high demand chasing restricted supply.
All appears well in the corporate-bond market at the moment; the default rate over the last 12 months has been just 1.6%. But the market has become steadily more risky over time: according to Standard & Poor’s, a rating agency, 71% of new issues in 2013 were rated B (putting them in the speculative, or junk, category); in the 1990s the average was just 31%. Such bonds may not be a problem right now but when times are rough, they are very vulnerable. In 2009, 11.1% of such bonds defaulted—and 21% of those rated B-.
When the market does turn, a vicious circle could develop. As Mr Baweja points out, central bank actions have suppressed both the risk-free rate (government bond yields) and credit spreads. Eventually, both will rise in tandem, creating a double whammy for bond investors.
The result may resemble a panicky audience in a crowded cinema after a fire alarm goes off. Marketmakers are unlikely to be able to absorb a sudden batch of sell orders; Goldman Sachs reckons that dealers’ inventories of corporate bonds are 40% lower than they were in 2006.
For bond funds, such as exchange-traded funds, the effect may resemble a bank run, as retail investors, alarmed by losses, rush to sell their holdings, prompting further sales of corporate bonds and even bigger losses. It probably won’t happen next week, or next month, so investors are taking the extra yield while they can. But that is the problem; few head for the exits until it’s too late.