Liquidity and Leverage
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Key Market Developments that Took Place During the March 2020 COVID-19 Market Turmoil
On 9th January 2020, World Health Organization (WHO) announced that the Chinese government had identified a new virus causing serious respiratory issues in the city of Wuhan. The number of infections continued to increase, and on 19th January, WHO confirmed that there was a transmission of the virus among humans.
On 23rd January, the city of Wuhan was locked down, followed by travel restrictions on various parts of China. New cases of infections were also reported in some parts of the world. Global equity markets, particularly in Asia, declined. On 19th February, stock markets reached record highs in the US and Europe.
In late February, the number of coronavirus cases continued to increase worldwide, increasing fear among investors. On 21st February, the government of Italy imposed a lockdown in the Northern towns with a high number of cases. Measures taken to help curb the spread of the virus during this period include lockdowns, travel bans, and the closure of schools.
Bond yields across the maturity spectrum declined substantially as managers came under pressure to rebalance their portfolios and turn their attention toward the so-called safe assets. As the number of cases in Asia and Europe continued to rise, the prices of safe assets such as US Treasuries and German bunds increased rapidly. As a result, selling some risky assets became difficult, and market liquidity was reduced significantly.
In addition, funding stress indicators and illiquidity measures started increasing considerably. Corporate bond spreads and spreads on sovereign bonds increased quickly and substantially to reflect the uncertainty in financial markets. The number of transactions, especially for equities and US Treasuries, increased considerably while liquidity, including in derivative markets, declined. Funds invested in equities and fixed income started flowing moderately and eventually turned negative at the beginning of March.
In early March, crude oil prices dropped substantially following the failure of OPEC+ countries to agree on a formula for cutting output to maintain stable oil prices amidst the weakening demand brought about by the rapid spread of the virus. This, in turn, increased the pressure on equity markets.
How Financial Participants Sought Safety
In mid-March, even the prices of the safety and highly liquid assets such as government bonds declined. On 11th March, WHO declared the COVID-19 outbreak a pandemic. During this time, several states announced containment measures such as lockdowns, border closures, and quarantine requirements for those travelling from highly-affected areas. Unceasing downward revisions coupled with high future uncertainty gave rise to extreme investor behaviour and sharp market movements.
First, the demand for cash and near-cash assets increased rapidly, underpinned by the precautionary demand for liquidity in the real economy. The concerns of corporates and households about the massive loss of their revenues, the fear among investors about the outlook of the global economy, and the need for cash by financial institutions led to massive selling of financial assets, including the safest and high liquid ones.
Signs of severe stress started to be exhibited on the commercial paper (CP) and certificate of deposit (CD) of the money market with outflow from non-government MMF’s in the US and Europe. As a result, there was selling pressure on the assets held by these funds. Funds on equities and bonds, in emerging market economies (EMEs) and developed ones, experienced very large outflows following investors’ act to liquidate their positions. Even the safest assets, such as US Treasuries, were affected by the selling.
Lack of liquidity was also a matter of concern for benchmark providers of fixed income in corporate bond markets. Some even postponed their end-of-March index rebalancing.
Second, corporates had limited market funding due to a sharp tightening of financial conditions. Many markets continued to experience a lack of liquidity. While electronic markets experienced a considerable increase in volumes coupled with wider spreads, intermediate dealer markets, for example, for corporate bonds, on the other hand, experienced a decline in liquidity. The increased number of trading activities led to a rise in settlement failure across asset classes since market participants faced challenges in delivering securities while many of their employees were working from home. Demand for commercial paper fell considerably thus, issuers could not issue more of them. Markets for commercial paper (CP) and certificate of deposit (CD) were shut down for some days. Due to tight financing conditions, corporates were forced to sell their investments and even go ahead to draw down their bank credit lines and revolving credit facilities.
On 16th March, the S&P 500 saw a loss of 12%. Market depth in a number of asset classes fell to levels similar to those experienced during the 2008 financial crisis. As a result, transaction costs increased significantly in many inter-dealer markets.
Third, the longtime relationship in prices across different markets began to break down, including in the US Treasuries markets. Generally, during times of stress, equity prices fall while government bond prices rise. However, when there is extremely high demand for cash and near-cash assets, prices of both equities and government bonds decline considerably. Volatility was raised even for assets such as gold and government bonds that are usually stable since investors took advantage of their prior appreciation to get the required cash. There was a large price difference between assets that usually trade closely.
Finally, extreme pressure in offshore dollar funding markets unfolded. The US dollar appreciated significantly against other currencies. This is because other corporates were not able to roll over funding, and thus they were forced to sell their dollar-denominated assets. The strain was severe, especially in emerging market economies (EMEs). Some non-US central banks were forced to liquidate some of their foreign exchange reserves in order to meet their dollar demands.
The Origins and Backdrop of the March 2020 COVID-19 Market Stress
The COVID-19 shock
The COVID-19 pandemic was an unmatched external shock to the financial sector. The outbreak and the measures taken by the government to contain the virus led to adverse shock to supply and demand. Lower demand was caused by lockdowns, quarantines, and social distancing, which reduced movements, while closure jobs and travel bans interfered with the global supply chain and trade. Several sectors such as tourism, automotive and services, and transportation experienced a sudden sharp retreat in real economic activity-which spread sequentially with the virus, giving rise to the deepest and most broad-based global recession since the Great Depression.
The difference between the COVID-19 shock and the 2008 financial crisis shocks is that the COVID-19 shock originated outside the financial system. In fact, core financial parts managed to absorb the shock, but we had severe disruptions in some financial markets. Demand for safe and highly liquid assets increased considerably as a result of the shock which transmitted through the system and transformed into a dash for cash.
Global economic and financial backdrop
The extremity of the reaction in financial markets in March may have been caused partly by developments in the lead-up to the pandemic. Recovering from the 2008 financial crisis took a long time which means that the outlook for growth and corporate earnings had deteriorated by early 2020 and become more unpredictable. There has been a significant drop in real interest rates during the past decade. Both authorities and market participants have predicted that there will be a “lower for longer” environment. The reduction in financial costs encouraged more borrowing as borrowers were relieved of their debt burden. The increased corporate indebtedness, the decreasing quality of assets, and lower standards for underwriting credit meant that the firm’s exposure to the economic downturn risk or an unexpected rise in interest rates increased significantly.
Several pre-existing conditions may have intensified the financial market’s reaction to the shock. The relatively easy financial conditions pushed valuation in some asset classes, compressed risk premia, and numerous sovereign debts having negative yields further contributed to a search for yield. As a result, some investors moved from high-quality cash-like assets down the credit curve. The popularity of investment strategies that rely on low market volatility, short-term funding, and high leverage may also have been increased.
Some concerns are related to vulnerabilities that are related to liquidity mismatches and the leverage build-up in some investment funds.
Structural changes in the global financial system
The covid-19 pandemic arrived at the end of a decade packed with enormous changes in the global financial system. There have been regulatory reforms, technological changes, and developments in US dollar funding, which have impacted financial resilience, intermediation patterns, and market functioning.
Changes in balance sheets and market structures of financial institutions have been contributed by post-crisis reforms. Large banks are better positioned to absorb losses since they’ve got more capital, liquidity and are also less leveraged.
Non-bank financial intermediation (NBFI) have seen significant growth over the past decade. Non-bank financial entities – including insurance companies, investment funds, and pension funds – now have different structures and regulatory frameworks within and across jurisdictions. Their asset share has increased to about half of global financial assets, compared to 42% in 2008, due to both inflows and valuation increases. This growth has been driven by long-term demographic trends resulting in the accumulation of assets, adaptive monetary policies, and search for yield. This has increased the importance of NBFI for the real economy. Financial services, as well as business models in that sector, have become more diverse. New market types have emerged while investments in credit products have increased.
The evolution in global US dollar funding has also been experienced in the past decade. The use of the US dollar currency for investment and funding across the globe has resulted in a network of relationships that are complex and spread geographically.
Electronic trading proportions have increased considerably in markets with more standardized products, such as stocks and in fixed income, especially futures and some government bonds. This has encouraged actively trading firms and new players to enter and provide liquidity in a number of these markets.
Structural changes that have impacted the resilience of the global financial system include:
Impact of the Pandemic and its Propagation on the Financial Markets
The impact of the COVID-19 shock on financial markets
The large shifts in demand and supply for market and funding liquidity raised concerns which the financial system had to cope with. As discussed below, several factors contributed to imbalances between demand and supply for liquidity.
Factors shifting demand and supply of liquidity
Demand for liquidity
At the pandemic outbreak, there was the uncertainty of revenues which prompted non-financial entities to attempt to source cash in capital markets to continue funding their activities. Financial corporates tried raising cash by (i.) tapping short-term funding markets, e.g., by issuing commercial paper and (ii.) increasing the issuance of corporate bonds.
However, these efforts did not bear long-lasting solutions because, in the first two weeks of March, CP issuance declined considerably and yields increased significantly, thus, funding became even more expensive. Issuance of bonds also became strained. Furthermore, issuance in the leveraged loan market came to a standstill, with no new deals coming on to the market in March. The issuance of investment-grade corporate bonds saw a remarkable decline. This forced many corporates to start borrowing from banks.
There was a global increase in the demand for the US dollar liquidity. In the face of economic uncertainty, non-financial corporates with US dollar-denominated debts opted to increase their US dollar cash holdings. The demand for the US dollar may have been influenced by the US dollar appreciation, which may have triggered margin calls on hedged positions.
An increase in volatility also triggered margin calls contributing to the increase in demand for cash.
Selling of particular assets and shifts in the portfolio of some money market funds (MMFs) is proof of increased demand for safest and highly liquid assets.
The impacts of COVID-19 differed from jurisdiction to jurisdiction, however, two distinct patterns observed in European and US MMFs include:
Redemptions from non-government MMFs, i.e., those that invest in short-term CP and CDs, saw a significant rise. There was about US$125 billion from US prime MMFs by the end of March. This contributed to the closure of short-term funding markets and hence a rapid increase in demand for short-term government bonds.
Inflows into government MMFs, particularly those that invest in short-term government bonds, saw a considerable increase. There were inflows approximately greater than US$800 billion in March for MMFs that invest in cash-like short-term debts.
A number of open-ended funds saw large redemptions. The equity and corporate bond funds for some emerging market economy (EME) and advanced economy (AE) reached a level not experienced since the 2008 financial crisis.
Exchange-traded funds (ETFs) are known to offer immediate liquidity since they trade on secondary markets. ETFs contributed to the key mechanisms for discovering price during the dash for cash. Primarily, we had relatively large differences between some fixed income ETF share prices and the estimated value of their assets.
Supply of liquidity
The ability of dealers to intermediate larger flows in several secured funding markets was reduced by regulatory constraints and internal risk management practices. In normal times, some secured funding markets, e.g., repo markets, allow the conversion of assets such as government and corporate bonds into cash. However, in times of stress, the demand for liquidity increased, and sales of such assets overpowered the ability of the dealers to intermediate in these markets following the pressure on their balance sheets. Repo rates increased significantly since market participants were struggling or being forced to pay higher prices.
There was also a considerable increase in volumes in various security markets, which the dealers could not handle fully. This led to the impairment of price discoveries in several markets, even those for safest and highly liquid assets.
Operational constraints may also have impacted the provision of liquidity and market-making during market volatility in March. Operational challenges relating to remote working, especially in the earlier stages, may have impaired market functioning.
The propagation of liquidity stress
Mitigants and amplifiers of liquidity strains
Despite the market strain, CCPs remained buoyant. The increased application of central clearing reduced the demand for aggregate collateral by allowing for the multilateral netting of exposures and payment obligations. Moreover, the extremely high volatility of asset prices and plentiful trading volumes resulted in a considerable increase in initial margin and variation margin flow.
One contributor to the increased demand for cash is margin calls. The number of margin calls for cleared derivatives increased significantly due to a rapid increase in the March volatility coupled with large transaction volumes and portfolio rebalancing. Many variation margin calls were also recorded in March 2020.
Various investors in open-ended investment funds may have been incentive to redeem before others. In mid-March, we had large differences between certain ETF share prices and their underlying asset value. The fact that ETFs are more liquid than their underlying assets implies that ETF share prices may have reflected more current market information than the value of their underlying assets.
The use of liquidity management tools to manage their liquidity. In Europe, for example, several funds used tools such as swing pricing, intended to reduce the investors’ incentives to redeem ahead of others.
Banks were probably unwilling or unable to deploy their balance sheets in a highly uncertain and volatile environment.
Propagation through short-term funding markets
Interaction of investors in CP markets propagated the stress. Amidst the risk aversion and the need for liquidity, investors were less willing to advance funds in the short-term unsecured market and fund CP with a maturity exceeding a few days. Strains in the short-term funding market may have been amplified by considerable redemptions from non-government MMFs that created a potential risk of depletion of the funds’ holdings of liquid assets.
Difficulties in accommodating large volumes of assets by dealers may also have amplified turbulence in short-term funding markets. The intermediation capacity of dealers was overwhelmed by the holdings of other numerous assets, resulting in constraints in balance sheets. Banks’ willingness to supply hedging services reduced, resulting in credit drawdowns by corporates.
Funding costs increased, leading to tough funding conditions.
Tighter dollar funding conditions impacted corporate that borrow in US dollars globally.
Propagation through core government bond markets
With the increased demand for cash and shorter-maturity assets, large volumes of long-dated Treasuries were sold by investors. Treasuries saw large inflows up to early March, with yields declining substantially. However, during the dash for cash, we had a train for selling in long-maturity Treasury bonds, and the yields increased sharply.
The increase of Treasury price volatility resulted in margin calls in spot markets for basis trade investors. The massive unwinding of these trades of about US$90 billion during March most probably contributed to the extreme illiquidity in government bond markets.
Foreign holders also sold government bonds they were holding which contributed to the pressure in the market.
The intermediation capacity of dealers in other assets, including government bonds, was constrained, which led to increased funding costs for corporates. This implied that the cost of borrowing increased substantially, and thus there was redemption in corporate bond funds. Following the selling pressure, dealers were forced to reduce the buying of corporate bonds. The trading costs increased considerably, leading to further illiquidity in the corporate bond market.
The reduced capacity of dealers to intermediate in some markets together with large assets sales led to further illiquidity and volatility in various markets. This triggered margin calls in centrally cleared, bilateral markets and in spot markets, which led to increased demand for liquid assets, which caused further assets sales and volatility.
Public Sector Responses
Several measures have been taken to alleviate market stress through different channels, including:
Purchase of assets by central bank-this aimed at providing indirect support to markets by increasing risk appetite, lowering risk-free rates, lowering market volatility, and improving market liquidity. The purchase of risk assets provided indirect support to markets by lowering risk premiums, thus increasing the risk appetite.
Liquidity operations by central bank-These operations provided liquidity support to the banking sector in broader terms in local currency. This contributed to stabilizing the funding rates and also indirectly provided support to other markets since banks used some of the new liquidity to buy assets or to lend to other market participants who in turn bought the assets. Some central banks increased the risk tolerances by broadening the pool of collateral they accepted.
Liquidity operations were also provided outside the US in dollars to help ease the dollar cash shortage directly. On 15th March, five central banks – the Bank of Canada, the Bank of England, the Bank of Japan, the ECB, and the Swiss National Bank –that had existing arrangements with the Fed reduced their prices and increased the frequency and tenor of their swap lines. On 19th March, nine countries, including Australia, Brazil, Denmark, Korea, Mexico, Norway, New Zealand, Singapore, and Sweden, entered into new agreements for swap line arrangements with the Fed. On 31st March, the Fed announced the introduction of a new temporary repo facility for foreign and international monetary administrations that would enable them to enter into repurchase agreements with the Fed.
Backstop facilities are designed to provide targeted liquidity to specific financial entities. These facilities offered direct support to market entities by providing them with liquidity. A good example is the Federal Reserve’s Primary Dealer Credit Facility, which aims to broaden the range of suitable counterparties by providing primary dealers with collateralized liquidity to help ease their intermediation constraint. In the Money Market Mutual Fund Liquidity Facility, the Federal Reserve lends to banks where the collateral is actually the banks’ assets bought from money market funds, hence directly supporting those funds. In the UK, the Covid Corporate Financing Facility purchased suitable, highly-rated CP from dealers, thus helping them to obtain liquidity.
In addition to these central bank interventions, regulatory measures have also been put in place in some jurisdictions. Authorities in numerous states and the Basel Committee on Banking Supervision (BCBS) have been encouraging banks to apply capital and liquidity buffers to support lending. This indirectly supports shortages in liquidity and the high demand for funding in the US dollar. Some authorities have temporarily relaxed compliance requirements, e.g., by temporarily modifying requirements for leverage ratio to leave out bank reserves at the central bank from the calculations of leverage exposure, in efforts to ease dealer intermediation constraints. In addition, there was a temporary amendment of the leverage ratio to exclude holdings of government securities in Canada and the US. In the US, bank purchases of assets were exempted from capital and liquidity requirements. The Fed also allowed several MMFs’ sponsors to purchase assets from their affiliates to reduce pressures on outflow directly.
Security regulators took a number of measures: the resilience of market infrastructures and investment fund liquidity was closely monitored; additional guidance was issued to market participants and ensured a continuous flow of information to markets.
Lessons Learned from the March 2020 COVID-19 Market Turmoil
The COVID-19 shock in March put scrutinized the resilience of the global financial system that has been largely reliant on intermediation based on the market to fund the increasing levels of debts. Financial resilience is the core of the liquidity of the market and provision of the capacity of the market as a result of the overall growth of NBFI.
The scope of the March 2020 economic shocks was unprecedented. With the scope and the size of the shock, we would tell to some extent, the degree of the financial stress to be expected. In fact, just like in previous cases, the shock caused risk repricing and increased demand for safe assets. The shock also caused large imbalances in demand and supply of liquidity needed for intermediation.
Fiscal, monetary, and prudential policy measures managed to stabilize markets. Fiscal policy measures shielded the real economy from the pandemic effects and supported credit supply. On the other hand, liquidity operations by the central bank provided liquidity support to the banking sector.
The liquidity strain in the financial system would have worsened if the central bank could not intervene. The financial sector would have suffered more as its capacity to raise funds would have been curtailed even further. By intervening, however, central banks took on material financial risk. In addition, aggressive policy measures could change the private sector’s expectations of future central bank actions. This could result in future moral hazard issues as markets would not fully internalize liquidity risk with the expectation of future central bank intervention in stressful times.
The central bank interventions are intended to restore the market functioning but not handle the fundamental vulnerabilities that cause the market to intensify the stress.
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