IMPLICATIONS FOR LIQUIDITY FROM INNOVATION AND TRANSPARENCY IN THE EUROPEAN CORPORATE BOND MARKET

OCCASIONAL PAPER SERIES NO. 50
AUGUST 2006, EUROPEAN CENTRAL BANK

Abstract:

This paper offers a new framework for the assessment of financial market liquidity and identifies two types: search liquidity and systemic liquidity.
Search liquidity, i.e. liquidity in “normal” times, is driven by search costs required for a trader to find a willing buyer for an asset he/she is trying to sell or vice versa. Search liquidity is asset specific.
Systemic liquidity, i.e. liquidity in “stressed” times, is driven by the homogeneity of investors: the degree to which one’s decision to sell is related to the decision to sell made by other market players at the same time. Systemic liquidity is specific to market participants’ behaviour.

This framework proves fairly powerful in identifying the role of credit derivatives and transparency for liquidity of corporate bond markets. We have applied it to the illiquid segments of the European credit market and found that credit derivatives are likely to improve search liquidity as well as systemic liquidity. However, it is possible that in their popular use today, credit derivatives reinforce a concentration of positions that can worsen systemic liquidity. We also found that post-trade transparency has surprisingly little bearing on liquidity in that where it improves liquidity it is merely acting as a proxy for pre-trade transparency or transparency of holdings. We conclude that if liquidity is the objective, pre-trade transparency, as well as some delayed transparency on net exposures and concentrations, is likely to be more supportive of both search and systemic liquidity than post-trade transparency.

JEL classification: G14, G15 and G18
Keywords: financial market functioning, liquidity, transparency, credit markets and financial innovation

자료: IMPLICATIONS FOR LIQUIDITY FROM INNOVATION AND TRANSPARENCY IN THE EUROPEAN CORPORATE BOND MARKET

※ 메모:

• The liquidity of US markets may be related to their size, the size of the US economy and the consequent use of the US currency as a vehicle currency for international investments. These are reasons why many non-US companies issue dollar-denominated corporate bonds.
• But financial market liquidity is also linked to the functioning of the markets and the way in which they are organised and regulated – features that, unlike market size, can be directly influenced by the authorities. Indeed, financial innovationis often a response to regulation and such innovation can play a big part in the evolutionof financial liquidity.
• It is commonly thought that liquidity premia are generally very negligible, except in small emerging markets, but while this may be true for euro-denominated sovereign debt issued by euro area governments or frequently traded equities, liquidity premia can be significant for many markets. It is important to note that only a few European corporate bonds trade on a daily or weekly basis, while the majority of tradable debt issues trade less than once a month or even once a quarter.
• Market participants argue that it is not just the level of trading liquidity that concerns them, but also its variability. An old banker’s joke is that a banker is someone who lends you an umbrella when it is sunny and asks for it back when it starts to rain. ... An extreme form of variability is a liquidity crisis. Almost all major financial crises, such as the Tequila crisis (1994-95), the Asian financial crisis (1997-98) and the LTCM debacle (1998), started off life as a trading liquidity crisis in markets or sectors that were considered reasonably liquid. The financial, economic and social costs of these crises may be large. Liquidity crises can destroy companies and paralyse countries. Preventing them is an important concern of the authorities.
• Two connected concepts relevant to liquidity crises are:
  
  (i) “artificial liquidity” – liquidity that appears to be there but disappears when it is needed; and
  (ii) “liquidity black holes” –specific periods when liquidity disappears, only to reappear a few days or weeks later.
  
  There is some evidence that both artificial liquidity and liquidity black holes have become more plentiful as a result of the way in which markets are organised and regulated and new instruments traded.
• The European Union and specifically the euro area corporate bond markets have experienced remarkably fast development, especially since the introduction of the single currency. According to Casey (2005), the outstanding volumes almost quadrupled in the euro area between 1999 and 2004, while the ratio of outstanding corporate bond issues to GDP closed significantly the gap to the United States’ long-term average of 25% of GDP, to stand at more than 16% at the end of 2004 (in 1999 the euro area share was a mere 5%).
• Financial instruments yield the risk-free rate of return (...) plus a premium for additional risks, principal among them being credit and liquidity premia.
  
  (1) The credit premium is the additional yield that investors demand as compensation for the risk of default as well as the volatility and unpredictability of this risk.
  (2) The liquidity premium of a corporate bond is the additional yield investors demand as compensation for the potential reduction in price they may have to accept if they require cash immediately and are forced to sell the bond.
  
• It raises a point we will come back to, that trading liquidity is often seen through the prism of instruments(some instruments are said to be liquid andothers illiquid), although this is perhaps better understood through the prism of market behaviour (a change in behaviour may make the same instrument go from liquid to illiquid or vice versa).
• It is possible too to see a tension between systemic liquidity and search liquidity. An environment where transparent electronic communication networks or exchanges undermine the role of market-makers and their balance sheets could be one where search liquidity is improved at the expense of systemic liquidity, and where reported bid-ask spreads narrow, but occasions of severe market dislocation become more significant and frequent. Foreign exchange markets are an example of markets where, during quiet times, quoted bid-ask spreads are wafer thin and for the euro/dollar market less than 2 basis points, reflecting minute search costs. However, the foreign exchange markets also frequently exhibit occurrences where the market appears to be in dislocation, jumping to new levels.
• Factors that increase systemic liquidity may reduce search liquidity. For example, heterogeneity in the behaviour of market players may improve systemic liquidity. If insurance companies and pension funds behave as long term investors and so, for example, a fall in the banking sector’s risk appetite for corporate bonds does not have an impact on them and they buy what the banking sector is selling, systemic liquidity is preserved. However, long-term investor behaviour usually results in a “locking up”of stock in various places away from the market-place, reducing the “free-float” of a bond issue and therefore increasing the search costs of trying to match buyers with sellers during quiet times.
• the so-called default swap basis or CDS-bond basis, namely the difference between the CDS spread and the par bond spread, expresses the degree of dislocation between the cash and the(unfunded) CDS market. A relevant proportion of the basis and its changes maybe explained in terms of liquidity factors and supply/demand imbalances.