Basel III recognises the dangers for banks providing unfettered liquidity in markets. It aims, alongside the introduction of the leverage, liquidity coverage and net stable funding ratios, to move financial institutions from providing zero capital supported liquidity to having adequate capital support for their peak liquidity needs. In another move, regulatory changes are also making bond portfolios more expensive to carry. More and more firms are revisiting their trading strategies. The recent hedge fund issue of Global Custodian covered the challenges facing prime brokers and hedge funds in some detail. The message was clear. The rules have changed, the appetite for certain types of business has changed and the future remains uncertain with continued regulatory ambiguity, evolving corporate structures and changing business focus.
The clampdown has created two material added risks. There is a much greater settlement liquidity risk. And, especially, in the bond markets, there is a material trading liquidity risk and collateral realisation risk. All have serious systemic implications and could mean we have sought to eliminate one form of systemic risk merely to replace it with another.
On the settlement liquidity front, the free liquidity offered traditionally by banks is now becoming expensive for both the lender and recipient. Quite simply they are both impacted by one or another of the new liquidity ratios. T2S is a case in point of a process that may need to change as a result. Its batch process is structured to enable banks to use efficiently their available liquidity as its overnight transaction cycles dovetail neatly with the intraday cycles of high value payment systems. But there is some ambiguity. In batch systems, such as T2S, there is a dependency on cash being freely available during the process to allow the bulk of securities to settle once they become available. If securities settlement becomes contingent on cash and stock, with cash being an ever scarcer resource as banks reduce limits for capital efficiency, the settlement process will not complete in the limited number of planned T2S overnight batches. Batch is much more liquidity intensive than trade by trade settlement systems, although these also need to adopt a maximum lot size for optimum efficiency.
This raises the question, in an environment where cash liquidity may decline, of whether batch or trade by trade settlement should be used. As a compromise solution, the CREST structure of multi mini batches allied to circles processing appears to have potential.
The intraday market will also be impacted by the values assigned to collateral. Much has been made of collateral shortages. Little comment has been forthcoming on the potential for increased haircuts, and thus added demand, as a result of the reduced liquidity of bond markets. The scale of the shift to illiquidity has been under reported. In the 18 months to December 31st, US banks moved $293 billion of their securities to their “held to maturity” account. This had P&L accounting benefit but also highlighted a change in market liquidity as 20% of the banks’ portfolios were deemed illiquid against just over 10% eighteen months earlier. Broker data also reveals a decline of around 40% in the broker quotes per trade, while RBS estimated there had been a 90% drop in credit market liquidity since the halcyon days of 2006. Some markets, such as the UK corporate bond market, are almost moribund with companies taking advantage of low euro yields and investors seeking more liquid securities.
We are currently at a preliminary stage of true liquidity management with data gathering and analysis being the focus of most banks. But the obvious implications of the data, and the mood music from Basle, recognises that liquidity is going to become both scarce and costly. Settlement platforms built on readily available cash or bond markets based on zero cost liquidity are past their sell by date for both the buy and the sell side. The regulatory focus on liquidity based systemic risks may seem academic to some, given their micro term to maturity. But any crisis in this segment is potentially cataclysmic given its quantum in a limited market place with substantial interdependencies.
What are the likely consequences? As suggested above, securities settlement could well need to move, in the next iteration, from batch bulk processing to real time or multi mini batch structures. Cash platforms will become more dependent on the major participants’ net start of day cash position with limited additional intraday credit available ; a factor that could lead to a reversal of the longer term trend for direct participation in such platforms. Collateral supply to demand will move against the takers with a less liberal view of non-prime, less liquid securities and, as a result, less availability.
At a market level, this has the potential to create a vicious circle of lower activity and thus even less liquidity. And, with lower trading profits reducing investment and corporate bank profitability, the remaining givers of liquidity are likely to focus on takers with the highest potential for contribution to net revenues. It will be a difficult era for the small players. It will be a barren landscape for the high frequency trader and activity based hedge funds. And it could well move markets to focus on value investment as active portfolios carry an ever greater risk of market illiquidity with growing potential for portfolio gridlock.