Monday, August 31, 2015

PWC Studies the State of Global Financial Market Liquidity

PWC has published an August 2015 study commissioned by The Global Financial Markets Association (GFMA) and the Institute for International Finance (IIF) intended to examine the post-crisis state of global financial market liquidity.  Among its findings, the study concludes that current and future market liquidity is a subject of concern for market participants. It further recommends a review of the calibration of the reforms to date and the ongoing regulatory agenda, in order to properly understand and consider the effects of regulatory initiatives on market liquidity by asset class, and to consider whether upcoming regulatory initiatives could likely exacerbate the trends in liquidity.

According to PWC, post-crisis changes in global market liquidity has been masked to a certain extent by "quantitative easing."  When the stimulus of QE ends, however, real changes -- some perhaps dire -- may be in store:

"[N]otwithstanding the benign market environment encouraged by monetary stimulus, a combination of several factors, including banks reducing risk following the introduction of new regulatory frameworks, have contributed to a measurable reduction in financial market liquidity across various asset classes. The analysis indicates an early warning that this withdrawal of dealer liquidity to date has not caused measurable economic damage due to quantitative easing programs and extraordinary monetary policy that are reducing liquidity pressures, and because market participants are adapting by trading some instruments less frequently and in smaller sizes. However, following the unwinding of QE or in a stressed environment, liquidity risks and market fragilities are likely to be revealed, potentially resulting in higher volatility in financial markets."

In addition, the value of stable and robust global liquidty cannot be understated:

"We consider liquidity to be important for effective market functioning. Liquidity in financial markets facilitates the efficient allocation of economic resources through the efficient allocation of capital and risk, the effective generation and dissemination of issuer-specific information, and the effectiveness of monetary policy and financial stability. The financial crisis demonstrated the advantages of having a robust financial system which is able to absorb unpredictable shocks, while maintaining market-wide liquidity. We consider market liquidity to be invariably beneficial."

The report examines the effects on liquidity of regulatory reforms to date, the future outlook for liquidity, and a number of policy considerations.  By applying empirical measures, PWC highlights that, although the data does not support a conclusion that markets are less liquid now than before the crisis, it does make clear that policy-makers must keep liquidity in mind as a high priority going forward.

"In any study of this kind, the empirical data is of course capable of different interpretations particularly as to detailed cause and effect. But we think three things come out very clearly. First, market liquidity plays an absolutely crucial role in facilitating the efficient and stable functioning of markets and, by extension, economies. Second, the weight of empirical evidence does support a hypothesis that markets are less liquid. Third, for these reasons, the ongoing policy agenda should set the preservation or indeed restoration of market liquidity as a high priority. Our study highlights the importance of the role played by market makers in providing liquidity, which has diminished since the global financial crisis as the balance sheet capacity of market makers has fallen. This has led to reduced market depth. The implementation of further reforms are also likely to have significant implications for future market liquidity."

The leaders of the global groups who commissioned the study couldn't agree more. 

GFMA CEO Kenneth E. Bentsen, Jr.:  “Robust market liquidity is essential to efficient capital markets that can drive capital formation, investor opportunity and economic growth. PwC’s findings indicate the need for policymakers to engage in further analysis of the cumulative impact of the rules implemented before moving forward with any new rules that could impede the markets from fulfilling this role."

Tim Adams, President and CEO of the IIF:  “PwC’s report takes an important snapshot of recent market conditions and identifies key factors that are contributing to reduced liquidity in some financial markets. . .  “This is the beginning of an intensive effort to better understand and evaluate this complex and rapidly evolving issue and to periodically present our findings to policymakers worldwide. As the study illustrates, the cumulative impact of all recent financial reforms is not yet known. Regulators should take this opportunity to assess the total impact of recent reforms on market liquidity and consider it carefully before moving forward on any new rules.”