Many banks such as Barclays have a long history providing liquidity to markets, in particular the credit markets. It was a key component of their business. But as being a mega bank has been losing its luster lately, so, too, have the balance sheet benefits of providing liquidity diminished. In a report that uses the hashtag #LiquiditySqueeze in the ominously worded title “The Pre-crisis Perspective,” the bank report warns that limiting banks involvement in cash credit markets has reduced liquidity. Furthermore, the report pointed to an increase in trading costs as Dodd-Frank has pushed banks out of the role of market maker.

barclays-9-9-bid-ask-1 Credit Markets

Trading liquidity in credit markets has deteriorated since bank dealers out of market

Trading liquidity in credit markets has “deteriorated,” an independent report from Barclays noted. Dealers, many of them banks, have been withdrawing from the market is a result of Dodd-Frank, which is “keeping the liquidity environment challenged.”

This new market environment has resulted is a decline in turnover and a shift to lower bid / ask trades to mitigate transaction costs, Barclays Credit Research analysts Jeffrey Meli and Shobhit Gupta stated in a September 8 report. From the Barclays standpoint this “reduced portfolio flexibility and certainty of execution.”

Deutsche Bank had documented a similar situation earlier in the year.

The resulting squeezing banks out of the middle of cash credit markets has resulted in “waiting for a dealer to find the other side of any transaction means that investors likely have to wait longer to execute trades,” the report noted. Many trades today remain un-executed because dealers are unable to find offsetting counterparties, and volume concentration has resulted in the loss of flexibility for portfolio managers, which could be a contributor to tracking error, the author’s asserted.

The report came with a clear disclaimer that said the report “is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors under U.S. FINRA Rule 2242.” The disclosure further stated that “Barclays trades the securities covered in this report for its own account and on a discretionary basis on behalf of certain clients.”

barclays-9-9-bid-ask-2 Credit Markets

2006, 2010 and present day liquidity / cost analysis conducted

The report considered three distinct periods of time to develop its thesis that liquidity has been diminished since bank dealers were removed from the process.

In 2006, using block trades as a measure of liquidity, investors experienced a 1.6 basis point differential between the bid and the ask price. In 2010 that number moved to a 3.2 basis point spread and since 2010 the spread has remained relatively consistent.

The first stage was a significant increase in transaction costs, with a relatively limited change in trading patterns. In 2010, the average bid-offer on investment grade block trades had risen to 3.2bp, double the 1.6bp average from 2006. However, the only major change in trading behavior was a modest decline in turnover – from 108% to in 2006 to 97% in 2010 . Other aspects of trading did not change – “order” business as a fraction of total block trades held steady, as did the proportion of volumes in older versus newer vintage bonds. Perhaps one of the more interesting aspects of the report, which tracked liquidity during several phases in market history, was its analysis of liquidity.

From the period 2010 to 2015 the opposite trend was apparent.

Realized transaction costs were largely unchanged, conditioned by trade type. For example, an order-based trade on an older vintage bond required similar bid-offer in 2015 as in 2010. Trading patterns changed significantly, however. Overall turnover rates fell sharply, to 72% in 2015. Order business increased by about 50%, and volumes in older vintage bonds declined sharply.

The report claims that a “sharp increase in transaction costs” that has occurred since the 2008 financial crisis, correlated with lower trading volumes in credit markets. “These changes have mitigated the increase in overall bid-offer paid by investors, as a percent of the market outstanding, despite the sharp post-crisis increase in realized bid-offers for each individual category of trade.”

Bank claims liquidity is an unclear concept, but in fact liquidity is defined everyday in the market

The report claimed that “liquidity is an amorphous concept,” undefinable and unclear, while “there is no single statistic that can be used to measure it.”

With due respect to the report’s author, measuring liquidity in markets is done on a daily if now hourly basis by numerous public and regulatory concerns.

It not only can be defined, but it is defined to various degrees. Managed futures CTA strategies are known to measure market liquidity when deciding their position sizing. As well, certain high frequency trading strategies are acutely aware of the liquidity in markets – with a particular emphasis on liquidity limits and the point at which the bid-offer will move based on one-sided liquidity increases.

Liquidity formulas vary in not only formula constituents but importance placed on each component. Average daily volume is sometimes considered on its own or relative to volume consistency a rolling period of time. Liquidity is defined in part by considering the bid-ask spread, not only looking at the price differential but also the depth of market on a consistent basis.

After claiming that liquidity is an undefinable concept and that such statistics are “deceptive,” the report takes on the concept that liquidity isn’t a complete disaster since the banks were required to withdraw. “The fact that bid-offer has not increased since 2010 has been cited as evidence that liquidity has not deteriorated. But it could also be driven by investors’ responding to lower liquidity by concentrating their volumes in the most liquid securities and, thus, avoiding paying bid-offer in a low liquidity environment.”