Flash Crashes and Swiss Francs: Market Liquidity Takes a Holiday
IMF Blog, May 20, 2015
Source details
- Canonical URL
- Flash Crashes and Swiss Francs: Market Liquidity Takes a Holiday
Other formats
Bibliographic details
- Authors: Jose-Vinals
- Published: May 20, 2015
Overview: fleeting market liquidity and rising correlations
- Financial market liquidity can be fleeting: the ability to trade in assets of any size, at any time and to find a ready buyer is not a given.
- The April 2015 Global Financial Stability Report identifies a new aspect: asset price correlations have risen sharply in the last five years across all major asset classes.
- The increase in correlations has been associated with episodes of decreased market liquidity.
- Asset price correlations edge higher as volatility in financial markets increases, virtually across all major asset classes; this increase in correlations' spillovers is a characteristic of financial contagion.
Evidence and recent episodes
- Foretastes of illiquidity include:
- The October 15, 2014 flash rally in U.S. Treasury bonds, recording one of the largest falls and then rise over the last quarter century in the most liquid market in the world.
- The dislocation in foreign exchange markets following the Swiss central bank’s unexpected decision to end its policy curbing the value of its currency.
- The risk of illiquidity is particularly significant in:
- Many advanced economy corporate bond markets.
- Bond markets in emerging economies that are experiencing large inflows from investment funds.
- These liquidity crunch episodes have so far not exerted long-lasting adverse impact, but evaporation of market liquidity could result in more market stress with potentially adverse knock-on impact on the global economy and financial stability.
Catalysts and transmission channels
- Geo-politics and oil price decline:
- The very steep and rapid decrease in oil prices in the second half of 2014 put considerable strain on U.S. high yield corporate bonds markets—where energy companies account for 15 percent of the market—and on oil exporting emerging economy government bond markets.
- Even when oil prices have partly recovered from last year’s sharp decline, the volatility of oil prices remains high, indicating ongoing concerns of market participants about future oil prices.
- Divergent monetary policies and a stronger dollar:
- The United States looks set to begin tightening interest rates later this year, having already ended asset purchases last year.
- In contrast, the Euro Area and Japan are expected to continue very accommodative monetary policies in the near term.
- This divergence has set the stage for the appreciation of the U.S. dollar.
- The interest rate rise and prospect of further dollar appreciation could result in capital outflows from emerging economies and from high yield corporate bond markets back into U.S. Treasuries, testing market liquidity in high yield and emerging economy bond markets and adversely affecting financial stability.
Key statistics and precise observations
- Asset price correlations: risen sharply in the last five years across all major asset classes (as identified in April 2015 Global Financial Stability Report).
- Energy sector share in U.S. high yield corporate bonds market: energy companies account for 15 percent of the market.
- Noted dates and references:
- October 15, 2014 flash rally in U.S. Treasury bonds.
- April 2015 Global Financial Stability Report.
- May 20, 2015 (publication date of this blog post).
Policy recommendations to enhance market liquidity
- Strengthen market structures, including in government bond markets:
- Encourage market participants to provide liquidity in normal trading conditions.
- Options include rewarding primary dealers with incentives or obligating them to trade passively (by providing quotes) or actively (by actual transactions).
- Design circuit-breakers triggered during rare extreme volatility events to halt disorderly trading and allow time for liquidity to replenish.
- By buttressing participation in secondary markets in normal conditions, authorities may forestall deterioration of trading liquidity that could require circuit-breakers.
- Ensure continued market liquidity under stress through enhanced oversight:
- Enhance micro- and macroprudential frameworks to oversee liquidity within mutual funds and at the level of financial markets.
- Use effective tools such as ensuring that redemption terms in the asset management sector are better aligned with underlying market liquidity conditions.
- National supervisors should coordinate and provide consistent guidance to trading firms across major jurisdictions regarding appropriate risk limits on individual retail investors, exchanges and clearing firms.
- Exploit cross-border synergies and preemptive arrangements:
- Examine and exploit cross-border synergies in policies, including the preemptive creation of central bank swap lines.
- Regulators and monetary authorities should take into account dynamics posed by increased global asset correlations and periods of volatility when evaluating systemic risks in financial markets.
José Viñals, May 20, 2015.
