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BlackRock Investment InstituteSeptember 2012
Got Liquidity?
[ 2 ] G O T L i q u i d i T y ?
Richard Prager Head of BlackRock Trading
and Liquidity Strategies
Ewen Cameron Watt Chief Investment Strategist,
BlackRock Investment Institute
BlackRock investment institute
The BlackRock investment institute leverages the firm’s
expertise across asset classes, client groups and regions.
The Institute’s goal is to produce information that makes
BlackRock’s portfolio managers better investors and helps
deliver positive investment results for clients.
Lee Kempler Executive Director
Ewen Cameron Watt Chief Investment Strategist
Jack Reerink Executive Editor
What is insideFirst Words and Summary 3
Collateral damage 4
The Liquidity Challenge 5
Phantom Liquidity 7Supurna Vedbrat Co-head of BlackRock Market Structure
and Electronic Trading team
drivers of the Liquidity Challenge
New financial services regulations are facts of post-crisis
life. They are meant to reduce the risk of a new credit crisis
and to boost transparency to politically acceptable levels.
Banks and dealers have already started to comply by
pulling back from trading and selling “risky” assets.
Higher Capital Standards: Basel III requires banks to
increase equity to 7% of their risk-bearing assets by 2019,
almost three times the current requirement. Global banks
must hold an additional 2.5%. Banks can beef up capital
by raising new equity (costly because of little investor
appetite) or reducing risk assets (bad for market liquidity).
Banks must hold enough “high-quality liquid assets” to
match expected cash outflows in a 30-day period.
Proprietary Trading Curbs: The Volcker Rule, part of the
Dodd-Frank Wall Street reforms, limits proprietary trading.
Regulators elsewhere are implementing similar measures.
Chris Vogel Head of BlackRock Fixed Income
Trading, Americas
The opinions expressed are as of September 2012, and may change as subsequent conditions vary.
Bans and Taxes: Short-selling bans hurt liquidity in the
underlying instruments, especially because they typically
come at a time of market distress—when liquidity is
already challenged. Financial transaction taxes can
damage liquidity and ultimately raise costs for investors.
Back to Basics: Some complex and poorly understood
structured products blew up during the financial crisis.
Many investors are now avoiding them, harming liquidity
in credit markets. Meanwhile, regulators are changing the
landscape by requiring central clearing of many over-the-
counter (OTC) derivatives.
Ratings Downgrades: Ratings agencies are downgrading
sovereign debt and banks. The first forces banks to further
beef up capital to account for sovereign debt holdings that
are now seen as too risky. The second hurts their ability to
function as counterparties to OTC and other transactions.
B L A C k R O C k i n v e S T M e n T i n S T i T u T e [ 3 ]
First Words and Summary
Powerful forces are reshaping trading in financial markets:
raised capital requirements, curbs on proprietary trading, moves
toward central clearing of swaps and the steady drumbeat of
ratings downgrades of sovereign debt and global banks. These
changing regulatory and political tides, partly triggered by the
financial industry’s self-inflicted wounds of trading losses and
excesses, increase the risks of reduced market liquidity.
The likely end result? A more transparent but less vibrant
marketplace for many securities and higher costs for investors.
This means higher bid-ask spreads on individual securities,
price gaps in response to macroeconomic news headlines,
and—most importantly—less room to carry out sizable trades
without significantly affecting the security’s price.
Fixed income markets are showing the contours of this new
liquidity world. Ostensibly, these markets are booming. New
issuance is setting highs as companies take advantage of
record low interest rates. Yield-hungry investors are bidding
up prices of corporate bonds and other spread products.
Things are a bit clunkier beneath the surface. Traders are
splitting orders into small chunks to get them done. Liquidity is
concentrated in large and new issues, and drops precipitously
for smaller and older bonds. Liquid bonds are increasingly
trading at a premium to others. And nobody really wants to
contemplate what liquidity will look like once the bull market
in credit runs out of steam or reverses.
For now, there is still ample liquidity and a drying out in the near
future appears highly unlikely. But things are changing rapidly.
Investors do well to adjust to the new world of trading and keep
in mind we have only seen its very beginnings:
} Forget a return to the credit-fueled hey days of the early
2000s. Markets were awash in liquidity and leverage then,
with great market depth (the ability to carry out large trades
quickly with minimal market impact) and the tightest bid-ask
spreads on record. This was likely an anomaly.
} A “back to the future” scenario is likely. This means markets
with pockets of liquidity, price differentials based on how
easy it is to buy or sell a security, and a renewed appreciation
for skills to carry out financial transactions across a plethora
of trading venues. This exposes portfolios to risks but also
offers opportunities to smart investors.
} Watch market impact. Poor liquidity sometimes will mean
investors can allocate fewer funds to their best investment
ideas than they would like. A disciplined investor typically
evaluates if market depth is great enough to initiate a trade—
and, more importantly, can facilitate an exit. Compare it to
a lobster pot: Easy to get into, but tough to crawl out of.
} Perfect hedges are a mirage. The financial crisis showed that
liquidity is king and diversification often doesn’t work in times
of market stress. As a result, many hedges are going to take
the shape of blunt (liquid) instruments traded on exchanges,
rather than customized products that look great on paper. For
example, call options on long-dated US Treasuries currently
are a hedge against broad risk-off market moves.
} Liquidity can be used in relative value investing. This is a key
strategy in stagnant markets with bouts of risk-on/risk-off
trading as detailed in “Standing Still… But Still Standing” in
July 2012. Investors can take advantage of situations where a
security’s liquidity premium or discount runs counter to their
assessment of the underlying value. Those with long time
horizons can exploit illiquidity by picking up hard-to-trade,
discounted assets.
} Better price transparency does not necessarily mean better
liquidity. In fact, the opposite may happen. Dealers do not
like to advertise their holdings for fear of getting stuck with
them—especially at a time when it is becoming costlier to
hold risk assets on their balance sheets.
So What do i do With My Money?TM
Pre-Trade Homework: Evaluate an investment’s likely
market impact. At what price can you enter and exit the
trade? Some of your best investment ideas may have to
take a back seat.
Blunt Tools: Use liquid, exchange-traded hedges to protect
your portfolio. They may be imperfect—but at least they
are tradable.
Liquidity Opportunities: Investors with longer time
horizons can try to take advantage of price differences
between liquid and tough-to-trade securities.
[ 4 ] G O T L i q u i d i T y ?
Repo Regression european Repo Market Trends, 2001–2012
MA
RK
ET S
IZE
(€ T
RIL
LIO
NS)
Market Size ■Euro Share
EUR
O R
EPO SH
AR
E (%)
0
1
2
3
4
5
6
7
40
45
50
55
60
65
70
75
2001 2007 20112003 2005 2009
Source: International Capital Market Association’s European repo market survey. Note: Data based on bi-annual surveys. Data through the second quarter of 2012.
Collateral Damage
The world looks awash in liquidity. Central banks have pushed
interest rates to record lows and have gone on asset buying
sprees to resuscitate economic growth. Purchases of
government paper and other securities by the central banks
of the US, eurozone, China, Japan, Britain and Switzerland
have added almost $9 trillion in monetary stimulus since 2007,
according to Deutsche Bank research.
This geyser of monetary liquidity has not resulted in as much
credit creation as one might expect. In fact, money multipliers in
the developed world have steadily declined over the past decade,
keeping a lid on inflation in most developed countries. Why?
Credit ultimately is dependent on collateral—and investors have
become much pickier about collateral since the financial crisis.
They are highly selective and are hoarding safe-haven assets
such as US, Japanese, German and UK government bonds.
New regulations such as centralized clearing of OTC derivatives
are driving up demand for high-quality assets even more—and
encourage more hoarding of this elite (and by many measures
overpriced) group of government bonds.
The near-death of structured products (market-linked
investments that use OTC derivatives) shows the mirror image of
this trend: avoidance of assets seen as too risky. The business of
packaging and selling structured products underpinned much of
the trading in fixed income instruments during the Great Bubble
of the early 2000s. (It also generated huge investment banking
and trading profits—which were wiped out when the market
imploded.) This once thriving market is now a drag on liquidity.
Demand for structured products has dried up as investors prefer
“back-to-basics” strategies, and are suspicious of financial
engineering and fearful of risk. Financial intermediaries are
unable or unwilling to create and support new structured
products due to tighter capital rules and a general de-risking.
As a result, issuance of collateralized debt obligations (CDOs)
has imploded. See the chart below, left. This in turn has
dampened activity in other credit markets—even though
supply, demand and outstanding value of corporate bonds
and emerging market debt are at record highs.
Another example is the repo market, where banks access
funding from money market and pension funds in repurchase
agreements. This market shows the effects of risk aversion—and
illustrates how monetary policy is changing trading and liquidity.
The repo market has made a comeback from the crisis days,
when worries about counterparty risks and the safety of
underlying collateral slashed volumes. But new stresses are
showing up. The size of the European repo market, for example,
contracted 10% to a two-year low of €5.6 trillion in the first half.
At the same time, the number of euro-denominated transactions
hovered around a record low of 57%. See the chart above.
The declines show both decreasing risk appetite (mistrust of
counterparties) and the competing effect of monetary policy.
Two long-term refinancing operations (LTROs) by the European
Central Bank have given European banks access to easy and
cheap cash, reducing their need to tap the repo market.
CDO
ISSU
AN
CE ($
BIL
LIO
NS)
Issuance Outstanding
OU
TSTAN
DIN
G CD
OS ($ B
ILLION
S) 0
100
100
300
400
500
0
300
600
900
1,200
1,500
20022000 2004 2006 2008 20122010
A Great Credit Machine Grinds to a HaltOutstanding CdOs and issuance, 2000–2012
Source: US Securities Industry and Financial Markets Association. Note: Data through the second quarter of 2012.
B L A C k R O C k i n v e S T M e n T i n S T i T u T e [ 5 ]
The Liquidity Challenge
Investors usually hail inventory declines as good news. Falling
inventories point to a future increase in activity: Either demand
is strong or businesses need to restock—or both.
Not so in the world of trading. A decline in inventory typically
equals a decline in liquidity. If you have fewer items on your
shelf, chances are you sell less (unless you offer deep discounts).
This is what has happened in the corporate bond market. Risk
aversion and preparation for stricter capital rules have caused
dealers to empty their inventories. Inventories of US corporate
bonds now total $59 billion, down 79% from a high of $286
billion in late 2007. See the chart on the right.
Over the same period, the US investment grade bond market
grew by about half to more than $3 trillion, as issuers took
advantage of low rates and investors hunted for yield. The US
high yield market also grew, and now stands at well over $1
trillion. The mismatch between low trading inventories and high
demand and issuance is one factor that is restraining liquidity.
Dealers have swapped their corporate bond holdings for (mostly
short-dated) US Treasuries, courtesy of the US Federal Reserve’s
selling bills to buy long-dated Treasuries in “Operation Twist.”
BES
T-TO
-CO
VER
LEV
EL
($ C
ENTS
)
US High Yield Emerging Market DebtEuropean High Yield
0
50
100
150
200
250
2012201120102009200820072006
Rising Trading Cost Tide Best-to-Cover Levels of Fixed income Markets, 2006–2012
Source: MarketAxess. Notes: The best-to-cover level is the difference between the executed trade price and the second-best dealer bid/offer. Data in US cents of bond price levels. European high yield data from April, 7, 2008; other data from Jan. 3, 2006. All data through Aug. 13, 2012.
The Great De-RiskinguS dealer inventories, 2001–2012
DEA
LER
PO
SITI
ON
S ($
BIL
LIO
NS)
20032001 2005 2007 2009 2011
-200
-100
0
100
200
300
Corporate BondsGovernment-Sponsored Enterprise DebtTreasuries
Mortgage-Backed Securities
Sources: MarketAxess and Federal Reserve Bank of New York. Note: Data through July 11, 2012.
Dealer positions in US mortgage-backed securities (MBS)
have gradually increased and now outnumber corporate bond
inventories, resulting in a vibrant agency MBS marketplace.
This market is supported by three sets of bidders: the Fed,
banks adding “quality assets” to adhere to the new Basel III
capital rules and real estate investment trusts, as detailed in
“in the Home Stretch? The uS Housing Market Recovery” in
June 2012.
By contrast, falling dealer inventories of corporate bonds
are starting to challenge liquidity in those markets. Liquidity
constraints may not yet be visible or felt—but they are more
likely to get worse than better.
Things look good on the surface. Best-to-cover levels—which
measure the gap between the trade price and the next-best
offer—are way down from crisis levels. They rose during the
European debt crisis in late 2011, but are now only slightly
elevated from pre-crisis levels. See the chart on the left.
[ 6 ] G O T L i q u i d i T y ?
BID
-ASK
SPR
EAD
(BA
SIS
POIN
TS)
0
10
20
30
40
50
20032001 2005 2007 2009 2011
A New Bid-Ask Normal?Bid-Ask Spreads on uS investment Grade Bonds, 2001–2012
Source: MarketAxess. Notes: Bid-ask spreads are daily estimates in basis points. The dark blue line represents a smoothed-out average. Data through July 25, 2012.
Bid-ask spreads on US investment grade bonds show a slightly
constrained liquidity picture. Spreads are far off their 2008–
2009 highs, but elevated from last year and pre-crisis levels.
See the chart above. US high yield bid-ask spreads have
followed a similar path and now average $0.31, albeit with much
wider dispersion, according to trading platform MarketAxess.
More importantly, markets have become shallower. This has
led to increased liquidity concentration in new issues, and
liquidity dropping off for older issues or run-off securities.
PER
CEN
TAG
E O
F VO
LUM
E
0
10
20
30
40
50%
Odd LotsRound Lots Block Trades Micro Trades
201220112010
Work That Order! Trade Sizes of uS investment Grade Bonds, 2010–2012
Sources: MarketAxess and TRACE. Notes: Micro < $100,000; Odd = $100,000–$1 million; Round = $1–5 million; Block > $5 million. Data through June 2012.
MA
RK
ET V
ALU
E ($
TR
ILLI
ON
S)
TRACE Investment Grade Trading Volume ■Market Value Trading Volume as % of Market Value
2012E2010200820060
30
60
90
120
150%
1
1.5
2
2.5
3
3.5 PERCEN
TAGE O
F MA
RK
ET VALU
E
Sources: BlackRock, Barclays and TRACE. Notes: 2012 estimates are annualized first-half data. 2012 market value as of June 29, 2012.
For example, the top 2% of investment grade bonds by volume
rose to almost a third of overall trading in the first quarter,
according to MarketAxess. And the top quintile of bonds by
volume accounted for 93% of total turnover.
The liquidity is bunched up in large new issues. Only issues of
more than $1 billion and those less than a year old recorded
volume growth in 2011, according to MarketAxess. Liquidity of
older and smaller bonds dropped across the board.
The result? Many traders are now splitting up large orders in
US investment grade bonds to find buyers and sellers. The
average trade size was $381,000 in June, down 17% from a
year earlier. Trades of more than $5 million now make up 36%
of the overall volume, down from 45% a year ago. See the left
chart below.
Poor liquidity is depressing overall trading—even as yield-hungry
investors bid up prices and companies take advantage of historic
low financing rates by issuing more debt. Trading volumes hit a
high of nearly $3 trillion in 2009 and then leveled off. This year
volumes are on track to slightly exceed their 2009 highs—but
remain subdued as a percentage of the total value of outstanding
debt. See the right chart below.
As a result, highly liquid bonds now carry a premium of around
16 basis points over less liquid ones, according to J.P. Morgan
research. This compares with an average premium of about
6 basis points in the past seven years. See the chart on the
following page. By contrast, the MBS liquidity premium has
remained stable at 6 basis points (as measured by the spread
between Fannie Mae and Freddie Mac securities).
When Liquidity Dries UpTrading volumes of uS investment Grade Bonds, 2005–2012
B L A C k R O C k i n v e S T M e n T i n S T i T u T e [ 7 ]
The Liquidity PremiumPremium of Liquid uS investment Grade Bonds, 2005–2012
LIQ
UID
ITY
PREM
IUM
(BA
SIS
POIN
TS)
-10
0
10
20
30
40
20122011201020092008200720062005
Liquid Bonds Rich
Liquid Bonds Cheap
Average Liquidity Premium = 6 bps
Sources: J.P. Morgan and TRACE. Notes: The liquidity premium is the spread between US investment grade bonds of the same issuer with similar maturity and daily volume of $3 million or more (liquid) and $1 million or less (less liquid). Spreads are monthly moving averages. Data through July 26, 2012.
Phantom Liquidity
Things look hunky-dory in equities, with bid-ask spreads
ever narrowing. The average spread on S&P 500 stocks now
is slightly more than a penny, according to Morgan Stanley.
Thank decimalization, automation, the advent of high frequency
trading and a host of new trading venues.
In reality, these narrow spreads amount to nothing more than
phantom liquidity. Sure, the spread is a penny for 100 shares.
But what happens when you want to transact a million shares?
For most stocks, there’s no market. Consider:
} Block trades (trades of 10,000 shares or more) in S&P 500
companies make up less than 7% of total volume, down from
nearly 50% in the early 1990s. See left chart below.
} The average trade size of NYSE-listed stocks is down 75%
from the early 2000s. See right chart below.
Transparency at a Price
Many new rules call for more price transparency, including
for OTC derivatives and US municipal bonds. The hope is to
create a level playing field and boost liquidity by attracting
new market participants.
The opposite effect, however, is a real possibility: Some
existing participants may withdraw for fear of tipping their
hand if their trading books are broadcast.
This is not to say price transparency is bad—far from
it. It is merely to flag unintended consequences. These
outcomes may be temporary as markets adjust, they
may be permanent or they may not happen at all.
Whichever the case, it pays to be prepared.
Phantom LiquidityBlock Trades, Turnover and Trade Sizes of uS Stocks
Sources: Morgan Stanley and New York Stock Exchange. Notes: S&P 500 block trades are calculated by dividing each constituent’s dollar volume by the dollar volume of trades that exceed 10,000 shares. Daily data through July 26, 2012. Turnover is each SPX constituents’ daily volume as a percentage of its outstanding shares. Data through July 2012. Data for trade sizes of NYSE-listed stocks is through June 2012. All data are consolidated trading.
PER
CEN
TAG
E O
F D
AIL
Y VO
LUM
E
S&P 500 Block Trades
0
10
20
30
40
50%
200920072005200320011999199719951993 2011
0
250
500
750
1,000
0
0.5
1
1.5
2%
201220112010200920082007200620052004
NU
MB
ER O
F SH
AR
ES
Average S&P 500 Turnover Average NYSE-Listed Stock Trade Sizes
AVERAG
E TUR
NO
VER
Not FDIC Insured • May Lose Value • No Bank Guarantee
This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 2012 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents.
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The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation. Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.
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Lit. No. BII-LIQUIDITY-0812 AC6263-0812
High frequency traders would argue they play a crucial role in
providing liquidity. Critics contend they provide real liquidity
only in stocks that are already liquid.
Foreign exchange shows few signs of liquidity constraints, as it
is a flow business that does not carry a capital charge. Bid-ask
spreads on spot foreign exchange markets spiked during the
financial crisis but have since come down—although they remain
above pre-crisis levels in less-traded pairs such as the New
Zealand dollar and Norwegian krone. See the chart below.
BID
-ASK
SPR
EAD
(BA
SIS
POIN
TS)
Australian Dollar-USD Euro-Norwegian Krone
Euro-USDNew Zealand Dollar-USD
0102030405060708090
201220112010200920082007
Awash in LiquidityBid-Ask Spreads in Spot FX Markets
Source: BlackRock. Notes: Based on quarterly BlackRock survey of 15 to 19 foreign exchange dealers. Bid-ask spreads in basis points are based on the average spread on a $100 million transaction dealers commit to 90% of the time. Data through June 2012.
How We Tackle the Liquidity Challenge
BlackRock is pioneering new ways of doing business to
ensure clients have access to a full range of investments:
Capital Markets: A new desk that works with investment
banks to source fixed income directly from issuers. This
“originate to manage” model is meant to meet client needs
for new corporate bond issues, allow customization and
deliver intelligence about market trends.
Crossing and Matching: New trading platforms for equities
and fixed income. Internal crossing networks enable buying
and selling of securities between BlackRock portfolios and
client accounts. A trading network for institutional clients
allows access to a broad set of market participants.
eTrading: New systems to tap into the liquidity of electronic
trading venues. Already far advanced in equities, electronic
trading is just starting to transform fixed income and foreign
exchange markets.
Adding Brokers: An emerging brokers program targets
enterprises owned by women and minorities as well as
firms with regulatory capital of less than $2 million.
OTC Central Clearing: A central clearing entity such as
the Chicago Mercantile Exchange could become the
counterparty in selected OTC transactions and reduce risk.