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“Market liquidity second greatest threat to financial stability”

9 April 2015

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The Bank of England has brought to the attention of mainstream audiences a topic close to our hearts: the consequences a reduction in liquidity would have on the economy.

In their recent quarterly assessment (released at the end of March) the Bank of England’s Financial Policy Committee (FPC) listed reduced market liquidity as the second greatest threat to financial stability: ahead of cyber security and domestic risks; only behind global risks (e.g. from Greece and China).

The crux of the FPC concerns relating to market liquidity are that " investment allocations and pricing of some securities may presume that asset sales can be performed in an environment of continuous market liquidity, although liquidity in some markets may have become more fragile."

The reason for the Bank of England’s concern is simple: the economy as a whole relies on the smooth-functioning of the financial markets, and the presence of liquidity in the markets is fundamental to this.

Liquidity is essentially a measure of how easy it is to buy/sell an asset: ‘liquidating assets’ refers to selling assets for cash. Banks and institutions buy and sell assets in the markets constantly. To be able to trade, the bank (for example) needs to find someone willing to take the other side of its deal (someone with different investing / trading interests) at the time it wants to make it. To do this efficiently, buyers and sellers, borrowers and lenders have to be matched, and a balance found between them. Arranging this match-making directly takes time, which increases risk for the bank – and in turn pushes up costs for end investors. It’s much better for business if interested parties can trade quickly; therefore banks and institutional investors rely on trading with market makers (aka liquidity providers). 

Being a market maker is a highly complex profession. Market makers have to understand not only the products for which they make a market, but also their relationship to other financial products across many other markets. By committing to having quotes in the market, market makers are exposed to significant risk, which is why many market makers today rely on advanced trading technology to keep their prices up to date.

With the raft of new regulations coming in, market participants of all types will see significant changes to the requirements placed on them. This will significantly impact the business models of large participants, as well as potentially forcing some smaller participants out of the liquidity provision role, or even out of Europe entirely. Everyone concerned needs to be diligent in ensuring there’s no inadvertent detrimental impact on market liquidity.  It must be hoped that the new regulations will succeed in maintaining market liquidity, but the reality remains to be seen.

The views expressed in this blog post are the personal opinions of the author and do not necessarily reflect the official policies or positions of the FIA European Principal Traders Association or the Futures Industry Association.

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