Drivers of Liquidity: A Dealer’s Perspective...Source: Credit Suisse, as of June 11, 2013, Oliver...
Transcript of Drivers of Liquidity: A Dealer’s Perspective...Source: Credit Suisse, as of June 11, 2013, Oliver...
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Drivers of Liquidity: A Dealer’s
Perspective Jon Kinol
Head of Global Interest Rates
Credit Suisse Securities
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2
I. Definition of Liquidity and its Importance
II. Characteristics of Markets where there is a High Degree of Liquidity
Provided by Market Makers
III. Market Making in the New Capital and Regulatory Environment
IV. Conclusion
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Definition of Liquidity
Liquidity is the ability to transact at a low cost, on demand, without significantly affecting the price of the traded asset
Importance:
Market Liquidity Funding Liquidity
“Liquidity is like confidence. And, like confidence, liquidity plays a critical role both in establishing the conditions than can lead to a financial shock, and in determining whether that shock becomes acute, threatening broader damage to the functioning of financial and credit markets.”
“What role can policy play in reducing the vulnerability of markets to this type of dynamic?”
-Timothy F Geithner
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II. Characteristics of markets where there is a high degree
of liquidity provided by market makers
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Depth of liquidity tends to be much greater in larger
markets
5
Source: Credit Suisse, Official Sources, as of May 24, 2013
Government bond market Bid/Offer width
*JGBs for 1bn, 10bn and 25bn Yen, Japan Market Size in US$ equivalent
10mm 100mm 250mm Mkt Size
US 1c 2c 3c 11,416
Japan <1c 1c 2c 9,446
UK 1c 4c 7c 2,203
Germany <1c 3c 5c 1,468
France <1c 4c 12c 1,820
Italy 8c 25c 200c 2,488
Spain 15c 50c 300c 956
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Markets with greater volume/turnover tend to have
tighter bid/offer spreads
6
Source: Credit Suisse, as of May 24, 2013
March 2013 Turnover
(Volume % of Market)
10y Bid/ Offer
on 100mm
US 25% 2c
Germany 48% 3c
France 31% 4c
Italy 3% 25c
Spain 7% 50c
*JGBs for 10bn Yen
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Liquid two way markets need a diversified ecosystem of
market participants
Government Securities Ownership by Investor Type
7 Source: Credit Suisse, Official Sources
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Both Issuer behavior and issue characteristics can have
large impacts on security liquidity
8
Source: Credit Suisse, as of May 17, 2013
Issuer:
-Few surprises in announcements
-Strong communication and easily observable policy
Issue:
-Large issues tend to be more liquid, allow tighter bid/offer
-Known issuance calendar
Bid/offer widened after surprise
Bank of Japan announcement of
large asset purchase program
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
1-Mar-13 15-Mar-13 29-Mar-13 12-Apr-13 26-Apr-13 10-May-13 24-May-13
Bid/Offer (10yr JGB, bps)
April 4 BoJ announcement
Size (mm) 25mm 50mm 100mm
FHLMC 1.25 8/19 3,500 1.00bps 1.25bps 1.50bps
FHLMC 1.25 10/19 6,000 1.00bps 1.00bps 1.25bps
Size (mm) 25mm
DBR 6.00 6/16 3,750 25c
DBR 4.00 7/16 23,000 7c
Bonds w/similar characteristics, different sizes Bid/Offer width
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Deep funding markets provide dealers the confidence to show
two way markets, allowing participants to finance positions or
borrow securities
9
Source: Credit Suisse, Official Sources, as of May 24, 2013
*Bid/Offer on 100mm US or Euro
Bid/ Offer (bps)
Repo as % of Sovereign
Bond Market Repo Haircut
US 2c 24% 1.0%
UK 4c 22% 1.0%
Germany 3c 42% 1.0%
France 4c 22% 1.0%
Spain 50c 16% 5.0%
Italy 25c 12% 4.5%
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The more alternatives for hedging and managing risk, the
greater the comfort in providing liquidity and holding
positions on the balance sheet
10
Source: Credit Suisse, as of June 11, 2013
Bid/Offer Width for TIPS, Treasuries and Their Hedges
Options on above also provide risk management tools
10mm 100mm 250mm
US TIPS 0.50bps 1.25bps 2.25bps
Inflation Swaps 0.80bps 2.25bps 3.50bps
US Treasuries 0.14bps 0.30bps 0.40bps
Vanilla Swaps 0.25bps 0.40bps 0.50bps
Treasury Futures 0.10bps 0.16bps 0.24bps
Eurodollar Futures 0.06bps 0.06bps 0.13bps
UST Options 0.65bps 0.65bps 0.97bps
Swaptions .75bps 1.5bps 2.5bps
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The correlation breakdown between bunds and other
European bonds led to new instruments being created.
11
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™ service
0
50,000
100,000
150,000
200,000
250,000
700,000
750,000
800,000
850,000
900,000
950,000
1,000,000
1,050,000
1,100,000
1,150,000
Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12 Sep-12 Mar-13
Bund
OAT (rhs)
BTP (rhs)
700,000
900,000
1,100,000
1,300,000
1,500,000
1,700,000
-1
-0.8
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
Jan-06 Jul-07 Jan-09 Jul-10 Jan-12
Correlation of daily Yield Changes in 10y Bunds and BTPs
Bund Future OI (rhs)
Open Interest
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12
Source: Credit Suisse, Trade Web
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20
40
60
80
100
120
140
160
0
0.5
1
1.5
2
2.5
Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12
10y USTBest Bid/Ask (cents)
Avg Size (MM, rhs)
Bid/offer for BTPs have tightened as open interest in hedging instruments
grows
0
20
40
60
80
100
120
0
20
40
60
80
100
120
140
Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12
BTPS 3.75 Mar 2021Best Bid/Ask(cents)
Avg Size (MM,rhs)
10y Italian FutureOI (normalized)
Treasury bid/offer spreads have remained stable, whereas instruments with less liquid hedges tend to be more volatile, such as BTPs
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IV. Market Making in the New Capital and Regulatory
Environment
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The capital cost of market making in sovereign debt
has increased significantly post crisis
14
Approximate Equity Capital required to own $1 billion position, assumes single A non-Bank Financial counterparty, bonds
financed by repo, for one way trade without the benefit of margin or portfolio netting.
Source: Credit Suisse
Basel I Basel II Additions:
-RWA (Internal Ratings Based/Standardized)
Basel II Basel III Additions:
-RWA Calcs using Value at Risk (VaR)
-Incremental Risk Capital (IRC) charge
-Increased Capital Requirements (8% 15%)
-Credit Valuation Adjustment (CVA)
-Counterparty Credit Risk (CCR)
(US$ millions) Pre-Crisis
Post-Crisis
(Basel II/ II.5)
New World (Basel
III/ Dodd-Frank)
US Treasury/Bund/JGB $0.0 $1.6 $9.0
US Agencies $16.0 $16.0 $32.2
IBRD $0.0 $4.0 $9.0
CADES $0.0 $4.0 $9.0
Italian Gov' t Bond $0.0 $16.0 $78.7
Spanish Gov' t Bond $0.0 $40.0 $78.7
10yr US$ swap (uncleared) $0.20 $0.40 $0.60
10yr US$ swap (cleared) N/A $0.03 $0.10
TY Futures $0.00 $0.03 $0.10
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A Financial Transaction Tax could have significant
impacts on liquidity for all market participants as
dealers will pass along FTT costs
Source: Credit Suisse, as of June 11, 2013, Oliver Wyman
• Many bid/offer spread could widen 3x to 7x and as much as 18x for
the most liquid instruments with the tightest bid/offer spreads (FX
market estimate)
• Financial Transaction Taxes will also have significant impacts on
financing markets
Bid/ Offer Transaction Tax % Increase
HY Bond (5y, 1pt) 21.2bps 10bps 147%
IG Bond (5y, 5bps) 5.0bps 10bps 300%
France (5y, 5c) 1.1bps 10bps 1009%
Repo (O/N, 2bps) 2.0bps 10bps 600%
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The adoption of Dodd-Frank and Prudential Regulation
may impact the funding market
16
Source: TBAC
This may have material negative implications for sovereign liquidity in
stressed situations.
New margin and capital rules will increase demand for high quality assets,
which could become acute during periods of stress reducing government
bond market liquidity and creating problems in Repo markets
Incremental HQC
Demand1
1. Prudential Regulation 2. Market Regulation
(Derivative Clearing)
3. Market Regulation
(Bilateral Margin)
4. Economic
Environment /
Uncertainty
=
+ + + Increased prudential liquidity
requirements
Increased IM requirements for
cleared derivatives
Increased IM requirements for
non-cleared derivatives
Cyclical HQC investment
demand (FTQ flows)
$1.0-2.5tt • $0.8-2.0tt (normal)
• $1.8-4.6tt (stressed)
• $0.8-1.2tt (normal)
• $1.8-4.1tt (stressed) Varies (multi-$trillions)
Total “phased-in” potential incremental HQC demand (normal market conditions): $2.6-5.7tt
Total “phased-in” potential incremental HQC demand (stressed market conditions): $4.6-11.2tt + FTQ
Flows
Incremental drivers of HQC demand include the following:
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When collateral is horded, repo market fails can
increase dramatically.
17
Source: NYFRB, Credit Suisse
In periods of stress, the
depth and resilience of
funding markets is critical to
liquidity.
0
2
4
6
8
10
12
Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13
Italian 10yr Bid/Offer (bps)
Spanish 10yr Bid/Offer (bps)
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Dodd-Frank: Volcker Rule
18
Source: Credit Suisse, Federal Reserve, Oliver Wyman
• The Volcker Rule may negate the benefits of alternative hedges.
• A large numbers of issues inherently fragments liquidity, Volcker could
increase this fragmentation by reducing ability to inventory positions
-80,000
-60,000
-40,000
-20,000
0
20,000
40,000
1/07 6/07 11/07 4/08 9/08 2/09 7/09 12/09 5/10 10/10 3/11 8/11 1/12 6/12 11/12 4/13
Dealer's Net Longs ($mm)
6-11 year Treasuries (cash)
TY (inverted)
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Other Prudential Regulations that Impact Liquidity:
19
Source: BIS April 2013 Basel 3 Progress Report, Official Sources
Balkanization of Regulatory and Capital Environment
Multiple regulatory regimes globally, some banks operate under home capital
rules that are much stricter than the peers with which they compete
Basel III Leverage Ratio
Potential Wholesale Funding Changes
SEFS for Swap Trading
Trade Reporting for Swaps
Country Basel Rules Regulations (both implimented and pending)
USA 1, 2 & 2.5 Swap Clearing/Margining/SEFs, Volcker, CFPB, FSOC, Bi-laterial Margining
Switzerland 3 OTC derivatives rules pending, Bi-laterial Margining
EU 2.5 OTC Clearing/Margining Short Sale Regulation, Derivatives Standardization, FTT
Japan 3 Nearly all rules implemented except SIFI capital buffers, Bi-laterial Margining
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V. Conclusion
20
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Conclusions
21
Source: Credit Suisse, Federal Reserve, Oliver Wyman
• The greater the texture of a market the greater the liquidity.
• The mix of new prudential and market regulatory requirements could
incent behavior that may be detrimental to liquidity
• In stressed periods the markets are more susceptible to the pro-cyclical
nature of liquidity. This can cause increased reliance on public
institutions for liquidity, requiring faster and deeper policy response.
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Liquidity of various government markets
22
Source: Credit Suisse
0
20
40
60
80
100
120
140
DBR 2.500 01/04/2021
FRTR 2.500 10/25/2020
BTPS 3.750 03/01/2021
UST 10y
Cents