Goldman Sachs Assesses Global Liquidity Concerns And How To Address Them

The concern over liquidity seems fairly universal. Analysts and pundits have been sporadically warning about illiquid global markets from the United States to Kenya. The concerns have only escalated as commodity prices have dipped and anticipation of a rate hike from the Federal Reserve has risen.

A team of analysts from Goldman Sachs' global macro research division tackled the issue in a comprehensive report published Sunday. They looked at whether global markets really were too tight, the consequences of illiquidity and potential remedies to the problem.

A Real Issue

While the concern over liquidity may be widespread, the understanding of what liquidity means is not as universal. Richie Prager, head of global trading and liquidity, described market liquidity as buying and selling an underlying security without unjust market disruption.

According to Steve Strongin, head of global investment research for Goldman Sachs, "It's not that [people] can't get trades done." In fact, he said, volatility is actually lower in many markets than it was pre-crisis and bid-ask spreads are tighter. Instead, Strongin noted, the core complaint from Goldman clients has been that "they can't get trades done as quickly."

He provided an illustrative example: "One $10 million trade that historically may have taken a day to get done now needs to be split into 20 (twenty) $500,000 trades that take a week or two to execute." Strongin said that this situation is "uncomfortable" for investors who operate under a 24-hours news cycle and can't keep trades up with the flow of information. Furthermore, he believes that arbitrage strategies that capitalize on rapid identifications market dislocations have been rendered almost obsolete.

However, global liquidity troubles aren't just limited to equities markets. Goldman Sachs' co-head of global market research, Charlie Himmelberg, sees evidence of sluggishness in the corporate bond market as well – he highlighted strikingly low trading volumes.

But Mary John Miller, former Under Secretary for Domestic Finance at the U.S. Treasury Department, actually believes that "current market conditions show plenty of liquidity, which is in part fueled by central banks." She said that current concerns are largely anticipatory of what could happen when the Fed raises rates and rolls back its quantitative easing program.

The Root of the Problem

Strongin chalked up present liquidity insufficiency to the post-crisis regulatory framework. He cited "higher capital requirements and the Volcker Rule, which prohibits proprietary trading at banks." He believes both measures have made financial institutions more risk-averse. Particularly, he took issue with non-risk-based rules that prevent banks from executing low-risk, high-volume trades to aid clients in dire straits. He also believes bank clients are less willing or able to take on risk than they were pre-crisis.

Himmelberg backed up Strongin's rationale. He thinks that dealers in the bond market have been limited in the number of single-name positions they can acquire, because new regulations have reduced "dealer capacity for committing risk on a principal basis."

"We need to have confidence in our ability to exit a position," Ritesh Shah, COO of global credit for Citadel Investment Group, told Goldman Sachs. "The list of corporate bonds...where that is the case seems to shrink by the day." He said that his firm has moved from model-based, short-term investing to more fundamental-based, long-term investing to adapt to the decreased liquidity.

But, as Prager highlighted, the corporate bond market has actually almost doubled in size since the financial crisis. "There is more capital and risk being put to work, but the ability to intermediate risk in the current market structure is not keeping pace with that growth." Put simply, current legislation is hindering banks' ability to respond to a growing bond market.

Richard Ramsden, a large-cap bank analyst for Goldman Sachs, noted non-risk-related factors as well. Regulation "has both reduced the size and increased the costs of banks' balance sheets — limiting banks' capacity to lend or take on inventory, and making these core activities more expensive."

Interestingly, however, Shah doesn't believe that the laws themselves are what has driven down liquidity. Instead, he thinks that "the lack regulatory of clarity" and consistency on the part of enforcement by the SEC have "put off new entrants" and caused uncertainty within the bond market.

In Strongin's opinion, while these new regulations have reduced the likelihood of a bank-oriented financial meltdown like the one in 2009, he does worry about "market failures" resulting from the lack of liquidity. Ramsden was more reassuring, saying that the consequences of post-crisis legislation were "manageable" thus far. Prager believes that instead of some sort of crisis, there will more likely be a shift in the "way that markets behave."

Meanwhile, Miller maintained that liquidity concerns aren't related to financial regulation.

Several Solutions

The Goldman Sachs report highlighted multiple strategies that could pump liquidity back into global markets.

Strongin suggested that regulators allow banks more flexibility with regard to their balance sheets. "The goal should not be to enable more static leverage, but to allow short-term, dynamic balance sheet expansion so that banks are better able to execute lower-risk but balance-sheet-intensive trades, especially when those trades can help dampen market shocks."

Himmelberg, meanwhile, highlighted the potential role of fixed-income ETFs. He said that these securities often create more liquidity than they demand and can thus help grow overall market liquidity. But he also agreed with critics that "macro solutions" can't get the job done alone – single-name liquidity also needs a boost. However, he didn't provide any specific ideas on that front.

Richie Prager posited that digital technology could help circumvent some of the problematic regulation of the post-crisis era. Specifically, he suggested that electronic platforms that directly connect lenders to borrowers might be able to avoid banks whose ability to serve as risk intermediaries has declined. Furthermore, he said electronic trading platforms increase the speed of bond transactions. Nevertheless, Shah was a bit more skeptical, saying that "the electronic marketplace has not yet appreciably changed the liquidity environment for corporate bonds." He is waiting for a platform that will allow large-block trades to be conducted online.

And while there are many other suggestions as to how liquidity may be restored to global markets – including aggressive central bank policy – there is very little consensus as to the "right" strategy. Yet still, it is clear that liquidity concerns are becoming an increasing focus of both the financial and public sectors. The conversation about how to best deal with the challenges of the post-crisis era will certainly continue and mature from here.

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