What is Happening to Bond Market Liquidity?
Almost every day we read another salvo of arguments in the debate over whether bond market liquidity has been harmed by new banking regulations. Based on bid-ask spreads and most other standard liquidity metrics, bond markets appear to be about as liquid as they have been for a long time. Liquidity is worse, however, for larger-sized trades. If necessary to achieve financial stability, this is a cost well worth bearing.
The amount of liquidity offered to bond markets by large banks is markedly reduced. Large banks are stocking much smaller market-making inventories of bonds. Balance sheet space is treated like expensive real estate, available only to positions that can afford to pay rental fees that are now much higher.In the case of repurchase agreements, known as repos, access to bank balance-sheet space has been sharply increased by regulation. The three-month U.S. treasury-secured repo rates paid by non-bank dealers are now even higher than three-month unsecured borrowing rates paid by banks, a significant market distortion. Trade volume in the bank-to-non-bank dealer market for U.S. government securities repo is less than half of 2012 levels. European repo market liquidity has also deteriorated.
Repo market efficiency is an important ingredient in the general liquidity of developed bond markets. I will suggest some policy changes in this area, and discuss the implications of other ongoing changes in bond market structure, such as the changing roles of high-frequency trading and electronic trade platforms.
Professor Darrell Duffie
Stanford University, Stanford Graduate School of Business, The Dean Witter Distinguished Professorship of Finance,
Senior Fellow, Stanford Institute for Economic Policy Research and
Professor of Economics (by courtesy), School of Humanities and Sciences
Darrell Duffie is the Dean Witter Distinguished Professor of Finance at Stanford University’s Graduate School of Business. He is a Fellow and member of the Council of the Econometric Society, a Research Fellow of the National Bureau of Economic Research, a Fellow of the American Academy of Arts and Sciences, and a member of the board of directors of Moody’s Corporation since 2008.
Duffie was the 2009 president of the American Finance Association. He currently chairs the Market Participants Group, charged by the Financial Stability Board with recommending reforms to Libor, Euribor, and other interest rate benchmarks. Duffie’s recent books include How Big Banks Fail (Princeton University Press, 2010), Measuring Corporate Default Risk (Oxford University Press, 2011), and Dark Markets (Princeton University Press, 2012).