In March 2020, because the COVID-19 pandemic disrupted a variety 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 put up, we study liquidity provision by sellers in a number of monetary markets in the course of the pandemic: how a lot was offered, attainable causes of any shortfalls, and the results of the Federal Reserve’s actions.
Vendor Stock Positions in the course of the Pandemic
Sellers help market liquidity by intermediating buyer trades—for instance, by taking buyer promote orders into stock when consumers are absent. Therefore, adjustments within the measurement 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 business paper (CP) and investment-grade (IG) company bonds (dashed strains, 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) (stable strains, marked on the best vertical axis) are usually greater 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 lower stock in some markets however elevated or maintained it in others in March.
Internet positions that end result from substantial lengthy and quick positions usually tend to point out intermediation actions than one-sided positions—say, average lengthy however minimal quick positions. Utilizing the microdata underlying the combination vendor statistics, we plot the adjustments within the lengthy and quick positions in March 2020 averaged throughout 5 main sellers with vital market share in all securities (see chart under). Main sellers elevated each their lengthy and quick positions in markets the place sellers within the mixture elevated or maintained web positions in March (payments, notes and bonds, and company RMBS). In markets the place mixture vendor web positions decreased (CP and IG bonds), main sellers didn’t broaden stock however didn’t cut back it both. Thus, it seems that main sellers usually maintained intermediation exercise on the peak 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 had been introduced on March 23 to help 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, at the same time as 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. Finally, the Fed’s massive purchases of Treasury and agency MBS securities helped to accommodate the promoting strain.
Why Did Sellers Present Inadequate Liquidity?
Throughout crises, clients might promote in such giant quantities that sellers are reluctant to totally take up the orders into their stock, thereby impeding liquidity. Their reluctance might come up as a result of inner danger administration practices restrict their positions in instances of enhanced market volatility or as a result of the prices of holding extra stock are prohibitive (for instance, attributable to regulatory constraints). For instance, following the selloff in fixed income markets during the taper tantrum of 2013, sellers diminished each web positions and risk-taking.
Vendor danger administration. Elevated prices of taking over danger might 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 the third week of March. The IG bond unfold to Treasuries elevated earlier but additionally 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 enhance their web positions, and the price of doing so additionally rises, they’re uncovered to larger danger of being caught with extra stock. This stock danger will increase when market volatility spikes, as occurred in the course of 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 stage. A variant is stressed VaR through which the anticipated loss is calculated throughout a interval of economic stress. The chart under reveals that the typical VaR and confused VaR of the banks that the 5 main sellers are affiliated with elevated sharply in 2020:Q1, indicating larger danger publicity.
In sum, elevated vendor positions in the course of 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 steadiness 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 most important banks to carry a minimal ratio of three % of tier 1 capital to complete on- and off-balance sheet exposures.
Within the chart under, we present adjustments within the lengthy and quick 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 had been topic to the SLR). In reality, the chart signifies that unaffected sellers largely didn’t broaden their lengthy and quick positions and, in lots of circumstances, diminished them. In distinction, our earlier chart confirmed that lengthy and quick positions of main sellers didn’t lower and in some circumstances 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 complete leverage publicity, with a view to present sellers “increased flexibility to continue to act as financial intermediaries.” On March 19, 2021, the Fed announced that the short-term change to the SLR will expire as scheduled on March 31.
Enhancing Market Making Capability
How would possibly market making capability be improved? One suggestion is to implement central clearing which reduces the quantity of vendor steadiness sheet required attributable to improved netting of trades. Sooner settlement instances additionally assist sellers economize on steadiness sheet house. 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 enable, thereby decreasing the short-term promoting strain available on the market. One other suggestion is to scale back the prices of regulation. There have additionally been discussions concerning the composition of the investor base and increasing the number of primary dealers. Regardless of the method, the sharp decline in market liquidity in the course of the pandemic lends urgency to initiatives which may improve intermediation capacities of the vendor group.
Jiakai Chen is an assistant professor on the Shidler Faculty 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.
The best way to cite this put up:
Jiakai Chen, Haoyang Liu, David Rubio, Asani Sarkar, and Zhaogang Tune, “Did Sellers Fail to Make Markets in the course of the Pandemic?,” Federal Reserve Financial institution of New York Liberty Road Economics, March 24, 2021, https://libertystreeteconomics.newyorkfed.org/2021/03/did-dealers-fail-to-make-markets-during-the-pandemic.html.
Dealer Balance Sheet Capacity and Market Liquidity during the 2013 Selloff in Fixed-Income Markets (October 16, 2013)
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 put up are these of the authors and don’t essentially replicate 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.