A lot has been written about fixed income market liquidity. A lot of it is colored opinion. For a more nuanced approach we had to wait for the Bank for International Settlements to take a look at the problem. The study details some of the drivers of the liquidity crisis and hits the nail of the head when it comes to explaining the current liquidity crisis.
Some of the key takeaways:
- Electronic platforms reduce trading costs and provide a platform for price formation. (Not limited to market maker to buy side, but also buy side to buy side.)
- Risk-return reassessment by traditional dealers results in less willingness to make markets. Regulatory pressure results in less capacity to make markets!
- Large impact of regulatory reform on returns: "... for these simple pricing examples, the gross revenue required to yield a return on capital of 8% under a fully phased-in Basel III framework would have resulted in returns above 20% given the requirements pertaining under Basel II".
- Liquidity bifurcation will continue.
- Markets with less dealer-like market makers and more HFT-like market making are more "susceptible to abrupt bouts of liquidity deterioration".
- Some decisions to change market making strategies can have a reinforcing effect, e.g: banks stop market making as costs are too high --> decline in market liquidity--> higher costs --> less supply--->....
- Market Resilience comes at a cost.
- Pre-crisis liquidity was under-priced!
You can read the study here.