Continuing the Conversation on Liquidity

Tobias Adrian, Michael J. Fleming, and Ernst Schaumburg

Market participants and policymakers have raised concerns about market liquidity—the ability to buy and sell securities quickly, at any time, at minimal cost. Market liquidity supports the efficient allocation of financial capital, which is a catalyst for sustainable economic growth. Any possible decline in market liquidity, whether due to regulation or otherwise, is of interest to policymakers and market participants alike.

Over the next two weeks, we will publish ten blog posts that illuminate how market liquidity has evolved since the financial crisis. These posts build on a first series on market liquidity, published in August 2015, and a second, published in October 2015. Some of the posts in this third installment respond to comments by our readers, while others expand the analysis to additional markets or institutions. We also consider recent market illiquidity events. Below is a brief summary of the posts in the series:

• Has MBS Market Liquidity Deteriorated?
  by Rich Podjasek, Linsey Molloy, Michael Fleming, and Andreas Fuster. Agency mortgage-backed securities (MBS) are the primary funding source for U.S. residential housing. Illiquidity in the MBS market could lead investors to demand a premium for transacting in this important market, ultimately raising borrowing costs for U.S. homeowners. This post looks for evidence of declining agency MBS market liquidity, complementing earlier posts studying liquidity in U.S. Treasury and corporate bond markets.
• Corporate Bond Market Liquidity Redux: More Price-Based Evidence
  by Tobias Adrian, Michael Fleming, Erik Vogt, and Zach Wojtowicz. This post builds on earlier work on our blog that presented preliminary evidence on corporate bond market liquidity. The findings generated significant discussion with market participants, with some wondering about the magnitudes of our estimates, some asking about their robustness, and others questioning whether such measures capture recent changes in market liquidity. In this post, the authors revisit these measures in response to that dialogue.
• Further Analysis of Corporate Bond Market Liquidity
  by Tobias Adrian, Michael Fleming, Erik Vogt, and Zach Wojtowicz. Commentators have pointed out that measures of liquidity that average across all bonds might mask important differences among subgroups of bonds and that relatively illiquid bonds, in particular, have suffered the largest reductions in liquidity. We address this argument by considering how liquidity has changed over time depending on issue size and credit rating.
• Is Treasury Market Liquidity Becoming More Concentrated?
  by Michael Fleming. An earlier post showed that Treasury market liquidity appears reasonably good by recent historical standards. That analysis focused on the most liquid benchmark securities, largely because those securities have the best available data. However, focusing on the most liquid securities might mislead, as some studies report that market liquidity is shifting from less liquid securities toward the most liquid ones. This post looks at trading volume information reported by the Federal Reserve to investigate whether liquidity is in fact becoming more concentrated.
• Primary Dealer Participation in the Secondary U.S. Treasury Market
  by Michael Fleming, Frank Keane and Ernst Schaumburg. The recent Joint Staff Report on the U.S. Treasury Market on October 15, 2014, revealed that primary dealers no longer account for a majority of trading volume on the interdealer brokerage platforms. The authors show in this post that primary dealers maintain a majority share of secondary market trading volume once dealer-to-customer trading is taken into account. The authors also use survey data to characterize the dealer-to-customer market and discuss some of the potentially important gaps in the available Treasury trading volume data.
• The Workup, Technology, and Price Discovery in the Interdealer Market for U.S. Treasury Securities
  by Ernst Schaumburg and Ron Yang. The interdealer Treasury market shares many features with other highly liquid markets that trade electronically using anonymous central limit order books. The interdealer Treasury market, however, contains a unique trading mechanism, the so-called workup, which today accounts for the majority of interdealer trading volume. While the workup is designed to support liquidity, it may delay certain price-improving order book adjustments and therefore affect price discovery. In this post, we exploit the tight relationship between the ten-year Treasury note traded on the BrokerTec platform and its corresponding Treasury futures contract to explore the extent to which the workup affects trading in the interdealer market and highlight the impact of technological changes on trading behaviors.
• High-Frequency Cross-Market Trading and Market Volatility
  by Dobrislav Dobrev and Ernst Schaumburg. This post investigates the close relationship between market volatility and trading activity that is a long-established fact in financial markets. In recent years, much of the trading activity in U.S. Treasury and equity markets is associated with nearly simultaneous trading between the leading cash and futures platforms. These striking high frequency cross-market activity patterns that arise in both trading and order book data from U.S. Treasury markets exist in other asset classes and naturally lead to the question of how the cross-market component of overall trading activity is related to volatility.
• Are Asset Managers Vulnerable to Fire Sales?
  by Nicola Cetorelli, Fernando Duarte, and Thomas Eisenbach. Conventional wisdom suggests that an open-ended investment fund that has a floating net asset value and no leverage will never face a run and hence never have to fire-sell assets. In that view, a decline in the fund’s assets value will just lead to a commensurate and automatic decline in the fund’s equity—end of story. In this post, the authors argue that the conventional wisdom is incomplete and then explore how investment funds’ vulnerabilities to fire-selling and associated spillovers might create systemic risk.
• Quantifying Potential Spillovers from Runs on High-Yield Funds by Nicola Cetorelli, Fernando Duarte, Thomas Eisenbach, and Emily Eisner. On December 9, 2015, following a period of poor performance and large outflows, Third Avenue announced the liquidation of its Focused Credit Fund, halting investor redemptions. This caused turmoil among similar funds, highlighting the need to quantify the potential for systemic risk posed by open-end, high-yield mutual funds. This post first characterizes open-end mutual funds that may show similar vulnerability to redemptions and then quantifies the potential for fire-sale spillovers on other mutual funds if there were large hypothetical redemptions at “at-risk” funds.
• Did Third Avenue’s Liquidation Reduce Corporate Bond Market Liquidity? by Tobias Adrian, Michael Fleming, Erik Vogt, and Zach Wojtowicz. The announced liquidation of Third Avenue’s junk bond Focused Credit Fund (FCF) on December 9, 2015, sent ripples through asset markets and caused losses for many investors. Shocks of this kind tend to increase the demand for market liquidity, as investors revise expectations, reassess risk exposures, and rebalance portfolios. Fears of contagion may increase the demand for liquidity in assets only remotely related to a liquidating firm’s direct holdings. This post examines whether FCF’s liquidation affected broader corporate bond market liquidity and returns.

Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Tobias Adrian is the associate director and a senior vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Michael J. Fleming is a vice president in the Bank’s Research and Statistics Group.

Ernst Schaumburg is the head of analytical development and an assistant vice president in the Bank’s Integrated Policy Analysis Group.