In March 2020, because the COVID-19 pandemic disrupted a spread of economic markets, the ability of dealers to maintain liquid conditions in these markets was questioned. Reflecting these considerations, authorities took numerous steps, together with offering regulatory aid to sellers. On this submit, we study liquidity provision by sellers in a number of monetary markets through the pandemic: how a lot was offered, doable causes of any shortfalls, and the results of the Federal Reserve’s actions.
Vendor Stock Positions through the Pandemic
Sellers assist market liquidity by intermediating buyer trades—for instance, by taking buyer promote orders into stock when patrons are absent. Therefore, adjustments within the dimension of their stock positions can point out whether or not sellers are performing intermediation actions.
The chart under reveals that primary dealer web positions in industrial paper (CP) and investment-grade (IG) company bonds (dashed traces, marked on the left vertical axis) fall beginning the week of February 26 and backside out within the week of March 18 (for CP) and March 25 (for IG bonds) earlier than recovering in April. By comparability, vendor web positions in U.S. Treasury payments, Treasury notes and bonds, and company residential mortgage-backed securities (RMBS) (strong traces, marked on the best vertical axis) are usually larger or related in March as in comparison with their prior ranges–though web positions in payments fell sharply within the week of March 25. General, sellers reduce stock in some markets however elevated or maintained it in others in March.
Internet positions that consequence from substantial lengthy and brief positions usually tend to point out intermediation actions than one-sided positions—say, reasonable lengthy however minimal brief positions. Utilizing the microdata underlying the mixture vendor statistics, we plot the adjustments within the lengthy and brief positions in March 2020 averaged throughout 5 main sellers with important market share in all securities (see chart under). Main sellers elevated each their lengthy and brief positions in markets the place sellers within the combination elevated or maintained web positions in March (payments, notes and bonds, and company RMBS). In markets the place combination vendor web positions decreased (CP and IG bonds), main sellers didn’t develop stock however didn’t cut back it both. Thus, it seems that main sellers usually maintained intermediation exercise on the top of the pandemic.
Market Liquidity and Vendor Intermediation in March 2020
In CP and corporate bond markets, restricted vendor intermediation and heightened market illiquidity went hand in hand, and improved solely after the Fed’s actions. For instance, the Commercial Paper Funding Facility (CPFF) was introduced on March 17, and vendor web positions recovered the week of March 25. Equally, two corporate bond facilities have been introduced on March 23 to assist IG bonds. Liquidity within the company bond market improved on the announcement, and vendor web positions recovered within the week of April 1.
In distinction, whilst sellers maintained intermediation, market dysfunction continued apace in U.S. Treasury and agency MBS markets in March 2020. What accounts for this disjunction? One chance is that the quantity of liquidity offered by sellers was insufficient to meet the volume of customer selling, as proven for the company MBS markets. In the end, the Fed’s massive purchases of Treasury and agency MBS securities helped to accommodate the promoting stress.
Why Did Sellers Present Inadequate Liquidity?
Throughout crises, clients could promote in such massive quantities that sellers are reluctant to completely take in the orders into their stock, thereby impeding liquidity. Their reluctance could come up as a result of inside danger administration practices restrict their positions in occasions of enhanced market volatility or as a result of the prices of holding extra stock are prohibitive (for instance, because of regulatory constraints). For instance, following the selloff in fixed income markets during the taper tantrum of 2013, sellers lowered each web positions and risk-taking.
Vendor danger administration. Elevated prices of taking over danger could hinder sellers in taking over greater positions. Contemplate the market danger premium, which signifies the compensation required by buyers to bear danger, together with stock danger. The chart under reveals that the company MBS unfold to LIBOR spiked on March 9, when market-wide circuit breakers were triggered for the first time since 1997, and remained excessive by means of the third week of March. The IG bond unfold to Treasuries elevated earlier but in addition spiked on March 9 earlier than peaking on March 23. These outcomes recommend that sellers’ price of bearing stock danger elevated in March.
When sellers improve their web positions, and the price of doing so additionally rises, they’re uncovered to better danger of being caught with extra stock. This stock danger will increase when market volatility spikes, as occurred through the pandemic. A measure of danger publicity is worth in danger (VaR) which is the worst anticipated loss over a given time horizon at a given confidence degree. A variant is stressed VaR during which the anticipated loss is calculated throughout a interval of economic stress. The chart under reveals that the typical VaR and careworn VaR of the banks that the 5 main sellers are affiliated with elevated sharply in 2020:Q1, indicating better danger publicity.
In sum, elevated vendor positions through the pandemic, mixed with an elevated price of taking over positions, boosted sellers’ danger publicity, thereby limiting their capability to bear danger and make markets.
Regulation and vendor stability sheet capability. Regulation may additionally constrain vendor intermediation exercise by requiring sellers to carry extra capital for regulatory functions. For instance, the supplementary leverage ratio (SLR) requires the biggest banks to carry a minimal ratio of three p.c of tier 1 capital to whole on- and off-balance sheet exposures.
Within the chart under, we present adjustments within the lengthy and brief positions in March 2020 of unaffected sellers (that’s, these affiliated with banks not topic to the SLR). If the SLR was a binding constraint on vendor intermediation, then we would count on these positions to extend relative to the main sellers (all of whose affiliated banks have been topic to the SLR). In truth, the chart signifies that unaffected sellers principally didn’t develop their lengthy and brief positions and, in lots of instances, lowered them. In distinction, our earlier chart confirmed that lengthy and brief positions of main sellers didn’t lower and in some instances elevated.
On April 1, 2020, the Fed briefly allowed banks to exclude U.S. Treasury securities and deposits at Federal Reserve Banks when calculating their whole leverage publicity, as a way to present sellers “increased flexibility to continue to act as financial intermediaries.” On March 19, 2021, the Fed announced that the momentary change to the SLR will expire as scheduled on March 31.
Enhancing Market Making Capability
How may market making capability be improved? One suggestion is to implement central clearing which reduces the quantity of vendor stability sheet required because of improved netting of trades. Sooner settlement occasions additionally assist sellers economize on stability sheet area. Within the company MBS market, the Fed innovated in how it bought securities to permit sellers to reduce their inventory rapidly, a lot before market conference would in any other case permit, thereby lowering the short-term promoting stress available on the market. One other suggestion is to scale back the prices of regulation. There have additionally been discussions in regards to the composition of the investor base and increasing the number of primary dealers. Regardless of the strategy, the sharp decline in market liquidity through the pandemic lends urgency to initiatives which may improve intermediation capacities of the vendor group.
Jiakai Chen is an assistant professor on the Shidler School of Enterprise, College of Hawaii.
Haoyang Liu is an economist within the Federal Reserve Financial institution of New York’s Analysis and Statistics Group.
Asani Sarkar is an assistant vp within the Financial institution’s Analysis and Statistics Group.
Zhaogang Tune is an affiliate professor on the Johns Hopkins Carey Enterprise College.
cite this submit:
Jiakai Chen, Haoyang Liu, David Rubio, Asani Sarkar, and Zhaogang Tune, “Did Sellers Fail to Make Markets through the Pandemic?,” Federal Reserve Financial institution of New York Liberty Avenue Economics, March 24, 2021, https://libertystreeteconomics.newyorkfed.org/2021/03/did-dealers-fail-to-make-markets-during-the-pandemic.html.
The COVID-19 Pandemic and the Fed’s Response (April 15, 2020)
Treasury Market Liquidity during the COVID-19 Crisis (April 17, 2020)
The Commercial Paper Funding Facility (Might 15, 2020)
MBS Market Dysfunctions in the Time of COVID-19 (July 17, 2020)
The Impact of the Corporate Credit Facilities (October 1, 2020)
The views expressed on this submit are these of the authors and don’t essentially mirror the place of the Federal Reserve Financial institution of New York or the Federal Reserve System. Any errors or omissions are the accountability of the authors.