SEC Fixed Income Committee: Debate on liquidity metrics

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By Flora McFarlane.

The often narrow focus of liquidity metrics in research was raised as a concern by the first meeting of the Security and Exchange Commission’s Fixed Income Market Structure Advisory Committee (FIMSAP) on 11 January, with panellists suggesting a broader approach liquidity conditions in the fixed income markets.

“Liquidity remains the right starting point, while remembering the ultimate goal to discuss is the future state of the fixed income market,” said Michael Heaney, committee chair and board member of Legal and General Investment Management Americas and TP-ICAP highlighted the importance of discussions on liquidity for the committee

The most recent Fed report on corporate bond market liquidity for Q2 2017 showed a continuing robust primary market which the report put down to “opportunistic borrowing by firms at low corporate interest rates.”

Both investment- and speculative-grade corporate bond issuance volumes and yields in Q2 were slightly down on the same period in 2016, however.

Existing discussion on liquidity, including academic studies, regulatory reports, white papers, and media discussion, was critiqued for not providing the most useful information on present and future conditions.

The panel attempted to draw out the most important metrics to discuss, and the best approaches to take.

Traditional metrics, such as bid-ask spreads and trading volume do not provide much cause for concern on the state of liquidity in fixed income. However other metrics, such as dealer inventory, reveal structure changes in supply and demand that could have a significant impact on liquidity conditions.

Jeff Meli, co-head of FICC Research at Barclays proposed the importance of investor activity when examining the liquidity conditions of the markets. The head of research argued that investors are best placed to react in changes in market conditions, acting as markers of the changes in liquidity as well as the potential impact of lower liquidity to the market in stressed times.

The popular “shotgun approach”, Meli said does not lead to an understanding of how market participants and the markets are evolving, and leads away from a view of how the markets will react under stress.

Greenwich Associates’ Kevin McPartland also highlighted the importance of investor sentiment, which, although harder to identify in quantifiable data, is a key factor in understanding liquidity.

While the meeting continually touched the development of electronic trading and trading tools, the head of market structure and technology research at Greenwich emphasised the gut feelings of investors which, despite new technology, will always be present and an important metric to consider.

Another factor, which two panels touched on, was trades that are never executed and trades that never even leave the portfolio.

According to the panellists, these metrics, which are absent from much academic research and industry white papers, should not be ignored as they are further indicators of investor behaviour.

Citigroup’s global head of market structure and data strategy, Sonali Theisen, expanded on investor behaviour, presenting data that showed the diversity in the investment community has decreased, with the number of clients using top five dealers at over 50% in 2017.

Theisen proposed that bouts of illiquidity are more likely when activity is dominated by a few participants with similar strategies. Citi research shows that half of Citi’s volume on US investment grade bonds is with just 25 clients, which is put down to a function of client activity, rather than the bank’s approach.

Commenting on liquidity conditions for 2018 and 2019, all panellists agreed that the robustness of the market at the moment is that it will remain manageable.

Meli forecast greater use of portfolio tools from investors who are exploring the utility of new portfolio trades.

Citi’s Theisen said: “The continual trend towards low volatility and passive investing will contribute to less homogeneity in the market, which will see the depth of liquidity the most impacted metric. An important approach therefore is to improve the diversity of investment strategies.”

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