Is liquidity still simmering?

This article was written by Brad Foster, Global Head of Enterprise Data Content and Fergus Trenholme, Liquidity Product Manager at Bloomberg.

The COVID-19 pandemic is changing how risk is perceived globally. Market and Credit risk remain in focus across the industry, however liquidity risk metrics supporting the execution of trading strategies have once again fallen into the spotlight since the pandemic up-ended the apple cart in March 2020. To better understand the market impact of these unprecedented events, we analyzed liquidity in the fixed income market through 2020 using Bloomberg’s award-winning LQA market liquidity analytics.

A year for the books

Prior to the global outbreak of the coronavirus, average liquidation costs for fixed income securities were generally low; under 15 basis points for most issues. As the virus spread, risk premia increased markedly, in many sectors liquidation costs increased by a factor of 10x. As expected, government bonds benefited from a flight to quality, while both Financial and Non-Financial sectors exhibited significant increases in liquidation costs. In particular, the Basic Goods, Consumer Cyclicals and Energy sectors experienced some of the largest increases in liquidation cost.

Whilst average costs have fallen since the peak of the market volatility in March 2020, mean reversion to pre-crisis levels has not occurred.

Based on an analysis of circa 13 million fixed income trades from 2020 which feed Bloomberg’s LQA market liquidity analytics, there are two clear trends:

Average transaction costs took a long time to settle back to “normal” and even at the end of the year remained elevated, with average costs around 150% higher than at the start of 2020.
Variability of transaction costs has increased significantly over the year, on average increasing by a factor of 2. In cost-constrained environments, this uncertainty has an adverse impact on market making, asset allocation strategies, collateral optimization and the profitability of execution functions.

Whilst certain securities trade relatively frequently, typically these only make up a very small percentage of the security universe. Market liquidity measures around this ‘visible’ universe are available on screens.

Consideration of the ‘invisible’ universe requires a modelled approach.

LQA leverages Bloomberg’s vast amounts of trade and quote data to model the relationship between position size, execution cost, and liquidation horizon at the individual security level on a daily basis even for securities with no recent trading activity. This provides users a data-driven approach to assess market liquidity for over 4 million securities across multiple asset classes under both normal and stressed conditions.

New year, new risks

2021 poses a number of risks to liquidity in the fixed income market, however, the probability and impact of these risks remains unknown. This includes regulatory driven risks such as:

Impact of the Settlement Discipline Regime from CSDR
Enhanced regulatory scrutiny in the US
Regulatory reviews of major fund structures and governance structures in the EU

As well as, risks driven by changes in market structure and behaviour:

Impact of potential reflationary pressures on asset allocation
Continued central bank asset purchase programmes
Increased global credit default trends
Continued growth in ETF fund vehicles and portfolio trading
Electronification of market making

The list is long but highlights that solely focusing on traditional risk measures may not be sufficient to optimize P&L and efficiently manage risk. Evaluating execution costs under normal and stressed conditions provides more clarity in an increasingly uncertain world.

Whilst we can’t predict the future, Bloomberg LQA offers the ability to mark liquidity to market using the latest market data to help you navigate the evolving liquidity landscape, where there may be another iceberg just around the corner.