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"Profound Shift In Liquidity Risk" May Imperil Market Function, New Report Says

Over the past several weeks we’ve said quite a bit about the lack of liquidity in both corporate and government bond markets. In a nutshell, QE is taking its toll on Treasury and JGB markets, with both traders and officials in Japan voicing concerns about liquidity while new regulations have made it more onerous for banks to hold inventories of corporate bonds, imperiling the secondary market at a time when new issuance is high thanks to record low borrowing costs. Here’s more:

Now, Oliver Wyman and Morgan Stanley are out with a new report that takes an in depth look at the issue.

From the note, on market conditions in general...

There's a liquidity conundrum in fixed income markets facing policy makers and investors: how it’s resolved will have long term investment implications across banks, asset managers and infrastructure players. 

 

At its heart is the huge shift in liquidity risks to the buyside and asset owners as the twin forces of financial regulation and QE have played out. New rules have driven a severe reduction in sell-side balance sheet and banks’ liquidity provision. Wholesale banking balance sheets supporting traded markets have decreased by 40% in risk weighted assets terms and 20% in total balance sheet since 2010. At the same time, credit markets have boomed as companies turn more to bond finance and investors are hungry for income. Credit market issuance is 2.4 times larger today than 2005. Within this, AuM in daily redeemable funds have grown 10% per annum and are now 76% above 2008 levels…

 

This comes at a time when we think the liquidity of secondary fixed income markets is likely to get materially worse. As regulatory costs continue to drag on returns, we expect another 10-15% shrinkage of fixed income balance sheet from the largest wholesale banks in the next 2 years. As much as 15-25% could be taken out of flow rates, we think, given the huge returns pressure on that business…

 

There is a growing urgency to tackle this debate by policy makers. The impact of less liquidity has been masked by a benign, ultra low interest-rate environment, but this is set to reverse in the US in the next 12 months, and could also reveal the side effects of QE pushing investors to less liquid securities.

...and on the impact of regulation…

We think the market underestimates how much more constrained market making will become in rates, credit markets and security financing. Wholesale banks’ risk weighted assets have already shrunk 40% since 2010 and balance sheet is down ~20%. Yet more is still to come – we expect a further 7-15% reduction in balance sheet over the next 3 years, focused in flow fixed income products…

 

Capital and funding requirements continue to ratchet up as banks deal with additional RWA and leverage pressures. We estimate that by 2017 capital consumption per unit of revenue generated in rates and credit intermediation will have increased 4-6x since pre-crisis levels. 

...and here’s a heat map…

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The report also contains quite a bit more in the way of policy reccommendations and implications for other market participants which we'll cover in a subsequent post.