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July 1, 2015

Recent Changes in the Resilience of Market Liquidity

Remarks by
Lael Brainard
Member
Board of Governors of the Federal Reserve System
at
Policy Makers’ Panel on Financial Intermediation: Complexities and Risks
for “The Future of Financial Intermediation:
Banking, Securities Markets, or Something New?”
Salzburg Global Forum on Finance in a Changing World
Salzburg Global Seminar
Salzburg, Austria

July 1, 2015

Recent events and commentary raise concerns about a possible deterioration in
liquidity at times of market stress, particularly in fixed income markets. 1 These concerns
are highlighted by several episodes of unusually large intraday price movements that are
difficult to ascribe to any particular news event, which suggest a deterioration in the
resilience of market liquidity. For example, on the morning of October 15, 2014, 10-year
U.S. Treasury yields gyrated wildly, and the intraday movement in Treasury prices was
6 standard deviations above the mean. In addition, after 4 p.m. on March 18 EDT of this
year, a meeting day for the Federal Open Market Committee, the U.S. dollar depreciated
against the euro by 1.75 percent in less than three minutes, an unusually large drop in
such a short interval. A few weeks later, markets experienced some very large intraday
movements in the price of German bunds during times of little market news.
In contrast, there have been a few notable episodes where market volatility was
clearly attributable to significant news but nonetheless appeared to evidence some
deterioration in the resilience of liquidity. For example, on January 15 of this year, the
announcement by the Swiss National Bank regarding the floor of the exchange rate
between the euro and the Swiss franc led to severe disruptions in foreign exchange
markets. Separately, the rise in bond yields in May and June 2013, the so-called taper
tantrum, also appeared to many observers to have been out of proportion to the news that
prompted it. 2

1

These remarks represent my own views, which do not necessarily represent those of the Federal Reserve
Board or the Federal Open Market Committee.
2
See Tobias Adrian, Michael Fleming, Jonathan Goldberg, Morgan Lewis, Fabio Natalucci, and Jason Wu
(2013), “Dealer Balance Sheet Capacity and Market Liquidity during the 2013 Selloff in Fixed Income
Markets,” FEDS Notes (Washington: Board of Governors of the Federal Reserve System, October 16),
www.federalreserve.gov/econresdata/notes/feds-notes/2013/dealer-balance-sheet-capacity-and-marketliquidity-during-the-2013-selloff-in-fixed-income-markets-20131016.html.

-2A reduction in the resilience of liquidity at times of stress could be significant if it
acted as an amplification mechanism, impeded price discovery, or interfered with market
functioning. For instance, during episodes of financial turmoil, reduced liquidity can lead
to outsized liquidity premiums as well as an amplification of adverse shocks on financial
markets, leading prices for financial assets to fall more than they otherwise would. The
resulting reductions in asset values could then have second-round effects, as highly
leveraged holders of financial assets may be forced to liquidate, pushing asset prices
down further and threatening the stability of the financial system. 3
Although anecdotes of diminished liquidity abound, statistical evidence is harder
to come by. Indeed, there is relatively little evidence of any deterioration in day-to-day
liquidity. Traditional measures of liquidity, such as bid-asked spreads, are generally no
higher than they were pre-crisis. Turnover, an alternative measure of day-to-day
liquidity, is lower, but it is unclear whether this reflects changes in liquidity or perhaps
changes in the composition of investors. The share of bonds owned by entities that tend
to hold securities until maturity, such as mutual funds and insurance companies, has
increased in recent years, which would lead turnover to decline even with no change in
market liquidity. In some markets, the number of large trades has declined in frequency,
which could signal reduced market depth and liquidity, but could also reflect a shift in
market participants’ preferences toward smaller trade sizes.
Finding a high-fidelity gauge of liquidity resilience is difficult, but there are a few
measures that could be indicative, such as the frequency of spikes in bid-asked spreads,
the one-month relative to the three-month swaption implied volatility, the volatility of

3

Of course, if the sharp reductions in asset values are fleeting, these second-round effects could be quite
limited.

-3volatility, and the size of the tails of price-change distributions for certain assets. We see
some increases in the values of these indicators, which provide some evidence that
liquidity may be less resilient than it had been previously. But this evidence is not
particularly robust, and, given the limitations of the existing data, it is difficult to know
the extent to which liquidity resilience may have declined.
As we continue to investigate quantitative evidence of the deterioration in the
resilience of liquidity in some of the financial markets, we are also trying to tease out the
various drivers of liquidity conditions, such as changes in regulation, trading strategies,
and market structure. Regulatory changes are often cited as a contributing factor.
Trading financial assets is a balance-sheet-intensive activity, and the Dodd-Frank Act,
has created incentives for institutions to carefully assess the risks of such activity through
stricter requirements on leverage, liquidity, and proprietary trading, raising the cost of
market making and possibly affecting market liquidity. Indeed, there is evidence of
reductions in broker-dealer bond inventories in recent years. Nonetheless, since not all
broker-dealer inventories are used for market-making activities, the extent to which lower
inventories are affecting liquidity is unclear. Moreover, reductions in broker-dealer
inventories occurred prior to the passage of the Dodd-Frank Act, suggesting that factors
other than regulation may also be contributing. In assessing the role of regulation as a
possible contributor to reduced liquidity, it is important to recognize that those
regulations were put in place to reduce the concentration of liquidity risk on the balance
sheets of the large, highly interconnected institutions that proved to be a major amplifier
of financial instability at the height of the crisis.

-4A second possible contributor may be the growing role of electronic execution of
trades across equity, Treasury, and foreign exchange markets and the associated
increasing role of high-frequency trading. Competition from high-frequency trading in a
particular market may reduce the attractiveness of that market for traditional (manual)
traders or slower automated traders, leading to a progressive shift in the composition of
market participants toward high-frequency traders (HFTs) over time. This shift could be
important to the extent that HFTs may have more limited capacity to support liquidity
resilience since, on average, HFTs appear to trade with smaller inventories and lower
capital than traditional traders. Although having less inventory and capital reduces the
cost of trading, it also means that markets increasingly dominated by HFTs may be less
able to absorb large shocks. Thus, liquidity may be sufficient and relatively cheap on
normal trading days, but it may not be deep enough to prevent large price swings when
demand for liquidity is significantly above the norm. This consideration would be most
relevant in the markets that are amenable to high-frequency trading, and automated
trading more generally, where assets are fairly standardized, such as equities and U.S.
Treasury securities, and less relevant in markets where securities are more idiosyncratic,
such as corporate bonds. It is also possible that markets that more readily lend
themselves to high-speed trading may be characterized by relatively greater concentration
over time. Achieving the speed necessary for high-frequency trading requires large
technology investments that necessarily may support a relatively more limited number of
market participants. Greater concentration in turn might be associated with lower
resilience at times of stress. The possible effect of HFTs on the resilience of market
liquidity is an important topic for future research.

-5Of course, other developments may be affecting liquidity in financial markets.
For example, market participants have indicated that changes in participants’ riskmanagement practices may be contributing to reduced market liquidity. In particular, the
experience of the financial crisis may have led many participants to reevaluate the risk of
their market-making activities and either reduce their exposure to that risk, become more
selective, or charge more for it, thereby reducing liquidity. 4
It is also worth noting the increased role of asset managers on the buy side of the
fixed income markets. During normal market conditions, the demand for liquidity from
this group of bond holders is likely relatively small, since asset managers acting on behalf
of retail investors generally buy bonds to hold them for some period. Moreover,
managers of open-end funds hold liquidity buffers that enable them to respond smoothly
to normal redemption demands. However, because the large increase in bond fund
holdings is relatively recent, little is known about how these funds will react to periods of
market stress or to abrupt changes in financial conditions and the adequacy of their
liquidity buffers for such situations. Because funds potentially allow daily redemptions
even against illiquid assets, it is possible that redemptions could be magnified in stressed
conditions as individuals try to redeem early, which in turn could lead to liquidations of
relatively less liquid assets, thereby amplifying price volatility and reducing market
liquidity.
If in fact liquidity resilience has declined recently, it may be a transitional
development that will be corrected going forward as participants adjust their risk

4

Another potentially important change in markets has been the increased prevalence of dark pools or
proprietary trading sites housed inside broker-dealers, which provide no information to the public about the
volume or prices of trades. It is possible this activity might be changing price discovery, although there is
debate over the net effect.

-6management practices, and the structure of these markets continues to evolve. For
example, if traditional providers of liquidity scale back their activity in response to
changes in regulation and market structure, over time, this shift may create incentives for
other providers, which are not similarly constrained, to step in.
Stress tests, such as those announced by the Securities and Exchange Commission
(SEC) offer one way to help ensure that market participants are prepared for sharper
spikes in market volatility. For instance, in the Federal Reserve Board’s most recent
stress test, the severely adverse scenario featured a large decrease in the prices of
corporate bonds.
We are in the early stages of data-based analysis of possible recent changes in the
resilience of market liquidity. An upcoming study of the October 15 event will shine
some light on the functioning of the U.S. Treasury market, but there is still much we need
to learn. More broadly, at the Board, we will closely monitor and investigate the extent
of changes in the resilience of liquidity in important markets, while deepening our
understanding of different contributors and how market participants are adapting.