Market Liquidity Not in Decline, but Prone to Evaporate
The new Global Financial Stability Report sheds light on the factors that determine the level and resilience of market liquidity, with a focus on the corporate bond market. In recent years, investors prepared to take more risks for a higher return on their investment, and accommodative monetary policies such as low interest rates and bond buying known as quantitative easing, have sustained market liquidity. However, structural changes such as a less diverse investor base, the proliferation of small bond issues, and banks’ retrenchment from trading suggest that once interest rates rise, liquidity will probably decline. A smooth return to more normal monetary policy in advanced economies is crucial to avoid sudden and disruptive changes in market liquidity, according to the IMF.
When markets are illiquid, asset prices become more volatile and less aligned with developments in the economy, and less informative about assets’ fundamental values. When market liquidity is low, the transfer of funds between savers and borrowers becomes less efficient. Investors may postpone investment decisions and economic growth will suffer. In extreme conditions, a sharp drop in liquidity can threaten financial stability since several asset markets, for example, bond and repo markets can freeze altogether—as seen in the global financial crisis.
Explaining market liquidity
Market liquidity depends, among other things, on the overall risk appetite of investors and on the funding constraints faced by financial intermediaries (Figure 1). The risk appetite of market makers—a bank or financial intermediary that stands ready to buy or sell financial assets—affects their inclination to trade. Changes in bank business models may also affect their willingness and ability to make markets.
Regardless of the activities of market makers, other factors such as search costs in the marketplace and investor characteristics also affect market liquidity. For instance, a positive development has been the emergence of electronic trading platforms, which has probably made it easier and cheaper for buyers, and sellers of financial instruments to find each other. Likewise, more trade transparency in bond markets has improved liquidity. Large scale asset purchases by central...
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