State Street’s Sean Greaves examines liquidity in a post-crisis environment and explains why regulators must be cognisant of the law of unintended consequences when devising new frameworks
The securities finance market has undergone significant change as it has sought to adapt to readily available liquidity and low interest rates, as well as the introduction of more stringent global regulatory requirements. These changes have affected all participants in well-documented ways and are expected to continue to challenge markets for years to come.
Lenders and borrowers alike have noted a shift in market demand as a result of post-2008 regulation and deleveraging of the market. This has resulted in lower spreads and volumes on the demand-side, although the supply side has seen a recovery to pre-crisis levels.
Liquidity was a major concern during the credit crisis, but has become less worrisome for investors as central banks around the globe pursued quantitative easing measures, some of which are still in place today. By contrast, the issue for investors is not so much around liquidity as it is returns in a low interest rate environment.
Questions remain over liquidity management going forward, but, as interest rates are showing the green shoots of growth, governments are expected at some point to pull back on their quantitative easing measures. Financial institutions are also beginning to feel the effect of global regulation aimed at liquidity management. This last point is especially interesting, as the requirements of regulation aimed at liquidity, such as the liquidity coverage ratio and net stable funding ratio, are having a profound effect on how institutions are approaching their financing requirements in both the short and long term.
Assessing the problem
Given the importance of liquidity management to investors, State Street commissioned a survey titled Let’s Talk Liquidity: Opportunities in a New Market Environment, in partnership with the Alternative Investment Management Association, the global representative of alternative investment managers. The results suggested that liquidity concerns are at the forefront of investors’ minds.
The survey also found that the almost half (47 percent) of global institutional investors believe decreased market liquidity is a secular shift, requiring a new strategic approach in order to succeed in the new and complex environment. Many US and European banks feel constrained in their efforts to perform their traditional roles as market makers, which has affected broader market liquidity conditions.
Furthermore, more than three fifths of respondents say current market liquidity conditions have affected their investment management strategy, with 36 percent rating this impact as significant. Managers must now reassess how they manage risk in their investment portfolios. More broadly, they are adjusting to a new liquidity paradigm in which trading roles have been transformed, new market entrants are emerging, and electronic platforms and peer-to-peer lending are changing the way firms transact their business.
The trend for borrowers to service their liquidity requirements through term lending can be seen in the data. Market benchmarking services such as IHS Markit, DataLend and FIS Astec Analytics all point towards an increase in shorter duration trades on specials and longer duration trades to meet financing requirements. For example, IHS Markit’s data shows that the average tenure of government bond loans climbed close to 200 days in September 2016, up from lower than 150 days as recent as June 2014.
So, what does the future hold for market participants? The questions that many participants continue to get to grips with are around data management and financial technology, as it becomes ever more apparent that managing liquidity in the modern environment is increasingly a question of ‘automation of information’, ie, how quickly market counterparties can react to market changes and mobilise their assets effectively.
State Street has long been at the forefront of big data and continues to build out its data management capabilities to set the pace for the industry. Where State Street has the advantage over many of its peers is its large client base and access to a larger pool of data. This will undoubtedly place State Street well in the global information race.
Fintech continues to be a topic of conversation in the industry, as firms seek to develop systems to help manage the data more accurately and quickly. Fintech development appears to be the most active area of investment and activity too, with the recent merger of IHS and Markit, as well as several institutions declaring their interest in developing blockchain technology, the whole industry could undergo some significant changes within the next few years.
Today, the market continues to face the pressing issues of how to simultaneously meet the needs of borrowers and lenders alike. This represents a difficult mismatch between borrowers seeking to finance inventories of low grade collateral versus lenders seeking to remain highly liquid in terms of their ability to recall loans and the collateral that they hold in lieu of securities on loan. Regulation aimed at preserving the integrity of funds, such as UCITS IV (and V), seems to occasionally be at odds with regulatory requirements aimed at increasing financial institutions’ liquidity.
For example, UCITS regulations put strict limits on the amount of securities that can be lent, as well as the types of collateral that can be held. It has long been a concern of borrowers and lending agents alike that such restrictions could make lending for these funds untenable as borrowers make the assessment that such trades are uneconomic. Should such sources of liquidity be unavailable to the market on economic grounds, then regulations may achieve the very end they were aimed at avoiding.
Another threat to market liquidity comes in the form of governments imposing taxes on the market, a good example of which is the financial transaction tax currently being considered by 10 nations in the eurozone. It remains unclear whether such a tax would apply to securities lending transactions, but even a minimal tax could have severe consequences for the financing market if it had to be applied on each transaction. Typically repo transactions involve chains of participants and if each leg of a repo has a tax applied, the whole chain of transactions would become uneconomic.
The good news for securities lending market participants is that whilest regulations have resulted in some reduction in liquidity, they have sothus far shunned the extreme options touted in some political arenas. For example, calls for an outright ban on short selling in various markets have not been adopted and it is to be hoped that regulators will continue to engage with the market participants on this and other important themes for liquidity.
There is no quick remedy to ensure market liquidity, but securities lending still plays a vital role in enabling an increase in overall market liquidity and price stability, and provides a flexible financing option outside of the traditional market-makers during times of stress. We remain optimistic that new opportunities will present themselves to market participants who demonstrate the flexibility and nimbleness required to take advantage of the new market environment.