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posted on 10 October 2015

Market Liquidity - Resilient Or Fleeting?

from the International Monetary Fund

Market participants in advanced and emerging market economies have become worried that both the level of market liquidity and its resilience may be declining, especially for bonds, and that as a result the risks associated with a liquidity shock may be rising. A high level of market liquidity - the ability to rapidly buy or sell a sizable volume of securities at a low cost and with a limited price impact - is important to the efficient transfer of funds from savers to borrowers and hence to economic growth.

Highly resilient market liquidity is critical to financial stability because it is less prone to sharp declines in response to shocks. Market liquidity that is low is also likely to be fragile, but seemingly ample market liquidity can also suddenly drop.

This chapter separately examines the factors that influence the level of market liquidity and those that affect its resilience, and finds that cyclical factors, including monetary policy, play an important role. In particular, the chapter finds that only some markets show obvious signs of worsening market liquidity, although dynamics diverge across bond classes. However, the current levels of market liquidity are being sustained by benign cyclical conditions - and some structural developments may be eroding its resilience. In addition, spillovers of market liquidity across asset classes, including emerging market assets, have increased.

Not enough time has passed for a full evaluation of the impact of recent regulatory changes to be made. Reduced market making seems to have had a detrimental impact on the level of market liquidity, but this decline is likely driven by a variety of factors. In other areas, the impact of regulation is clearer. For example, restrictions on derivatives trading (such as those imposed by the European Union in 2012) have weakened the liquidity of the underlying assets. In contrast, regulations to increase transparency have improved the level of market liquidity.

Changes in market structures appear to have increased the fragility of liquidity. Larger holdings of corporate bonds by mutual funds, and a higher concentration of holdings among mutual funds, pension funds, and insurance companies, are associated with less resilient liquidity. At the same time, the proliferation of small bond issuances has almost certainly lowered liquidity in the bond market and helped build up liquidity mismatches in investment funds.

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