U.S. bond market liquidity may have turned more fragile since the 2007-2009 global credit crisis due to a shrinkage of dealers’ balance sheets, the growth of electronic trading and other structural changes in the bond market, according to a New York Federal Reserve blog published on Wednesday.
A deterioration in market liquidity, or how easily bonds are bought and sold, has concerned investors and regulators in the aftermath of several episodes, in particular the “flash rally” in Oct. 15, 2014 when Treasury yields swung wildly within a 12-minute span without a fundamental reason.
Some market participants have blamed these episodes on smaller dealer balance sheets due to tighter regulations, which are aimed to safeguard the financial system with higher capital requirements for dealers.
“We find that dealer balance sheets have continued to stagnate and that various measures point to less abundant funding liquidity,” Tobias Adrian, an analyst at the International Monetary Fund, and New York Fed economists Michael Fleming and Or Shachar, wrote in their article, “Market Liquidity after the Financial Crisis.”
Dealers’ assets fell to $3.0 trillion at the end of 2016, down from a peak of about $5 trillion prior in early 2008 prior to the height of the financial crisis.
Because it has become more expensive for them to borrow in a more stringent regulatory climate, dealers have rolled back risk-taking and have become more reluctant to stake big bond positions, the analysts said.
Possibly due partly to less support from dealers, there has been a decline in the “depth” in the $14 trillion U.S. Treasury market, they said.
The average quantity of these government bonds that can be traded at the best bid and offer prices remained below levels seen before the crisis and 2013 “taper tantrum” but above the levels during the crisis, they said.
In the $8.5 trillion U.S. corporate bond sector, the average bid-ask spreads on institutional-sized trades remained above pre-crisis levels, they noted.
While these measures signal some decline in bond market liquidity, the deterioration is not widespread, they said.
“Although liquidity under normal market conditions may not have significantly worsened, it might be that it has become more fragile, or prone to disappearing under stress,” Adrian, Fleming and Shachar wrote.