RDP 2008-06: Promoting Liquidity: Why and How? 3. Reasons for Asset Market Illiquidity

In assessing potential policy directions it is worth first considering the reasons why not all assets can be sold in liquid markets and why, on occasions, liquidity can disappear from previously liquid assets. Importantly, there can be close correlations between reductions in market liquidity and funding liquidity. If market-makers (broker-dealers) have more difficulty obtaining funding liquidity, they will be less able to fund short-term holdings and so smooth imbalances in demand/supply over time, thereby reducing market liquidity. Similarly, if market liquidity is low, then a broker-dealer will have more difficulty obtaining a collateralised loan, or that loan will have a high margin, because the lender is less certain that the market price of that asset can be realised. Consequently, funding liquidity will also be low. Reflecting these interconnections, the following discussion focuses on four explanations for a lack of liquidity in the markets for various financial assets. These are:

• the existence of asymmetric information;
• a sudden rise in uncertainty;
• a lack of adequate market infrastructure; and
• the development of one-sided markets following troubles with a market participant.

3.1 Asymmetric Information

The first, and most obvious, reason for liquidity problems is the existence of asymmetric information between the potential buyers and sellers. If buyers are concerned that sellers know more about the quality of the asset than they do – either because they are unwilling to reveal, or unable to credibly reveal, the relevant information – they will be reluctant to purchase the asset unless this asymmetry can be overcome. This has, for example, been one reason why bank loans, particularly to small and medium-sized businesses, have typically not been traded in deep and liquid markets. Similarly, a rapid change in investors' concerns about the degree of information asymmetries can see liquidity in previously liquid markets dry up quickly.

As financial markets have matured, various ways of ameliorating the effects of asymmetric information have developed. One is for investors to rely on credit rating agencies, with many investors taking advantage of the economies of scale by delegating the monitoring of asset quality to these agencies. Another is for institutions to develop reputations for comprehensive and accurate disclosure. A third is for lenders to retain a financial interest in assets that they originate, that is, to keep some ‘skin in the game’. In securitisation markets this can be achieved by the lender, or a related entity, holding the first-loss tranche, or in syndicated lending by the lead lender holding a large portion of the loan. In addition, where possible, counterparty risk could be reduced by the novation of transactions to a central counterparty.

One of the main reasons that the recent strains in credit markets have been so pervasive is that investors' confidence in some of these antidotes to information asymmetries has been severely shaken. This is particularly the case in relation to structured credit products, but also for bank balance sheets more generally.

An important element here is that the reputations of the credit rating agencies have been badly dented. Over recent years, many investors have taken comfort in the belief that these agencies were spending the necessary time and effort to understand and assess the risk associated with a wide range of assets. As a result, many felt, perhaps inappropriately, that they did not need to fully understand the details of the investment themselves. When the difficulties emerged, these same investors began questioning whether the rating agencies had really understood the assets that they were rating (or had applied appropriate ratings), and whether they had been too close to those selling the assets.

A second factor is the perception that many banks have been slow to ‘come clean’ about the structure of their portfolios and the extent of their losses. This perception was reinforced by some banks writing down the same assets numerous times within a relatively short period. Some investors interpreted this as banks holding back information, at least initially, particularly given the lack of transparency about the exact assets that were in the portfolio, and how those assets were being valued. Similarly, when some banks announced write-downs this led to the perception that competitor banks with assumed similar portfolios that had made no announcement were hiding their losses. In turn, this generated increased concerns that banks knew something that outside investors did not.

3.2 A Sudden Rise in Uncertainty

A second reason that liquidity issues can emerge, including the loss of liquidity in previously liquid markets, is that uncertainty about the future increases suddenly. Here the issue is not so much that buyers think that sellers might have more information than they do, but rather that there is a general increase in uncertainty about the future economic and financial environment by both buyers and sellers of assets.

A high level of uncertainty is itself, of course, not necessarily an inhibitor to a liquid market, with many assets with highly uncertain pay-offs trading in liquid markets. Instead, the issue is more that liquidity can disappear when the degree of uncertainty suddenly increases. During such episodes, investors can come to question both existing norms of behaviour and the usefulness of the historical record in valuing assets. The result can be a significant reduction in the willingness to transact. When there are asymmetric pay-offs, an increase in uncertainty can also amplify the agency problem that an investor or lender faces.

In a sense, a rapid increase in uncertainty can itself prevent the market-clearing process, with investors choosing to stand on the sidelines until they have reassessed the risk-return characteristics of many assets. In this environment, because of the information asymmetries discussed above, sellers of assets can be seen as particularly desperate, further undermining the ability to sell assets.

Structured debt markets appear particularly prone to this problem. Credit derivatives also seem subject to evaporating liquidity; Fitch Ratings (2004), for example, found that for individual-name CDS, liquidity declined substantially when the relevant company encountered some form of stress. In contrast, in foreign exchange markets a change in the economic environment and a sharp increase in uncertainty can result in very large movements in prices, but liquidity is not normally absent for extended periods. One explanation for this is that in the foreign exchange market most of the factors that influence exchange rates are public knowledge, whereas in debt and credit derivative markets, periods of sharply increased uncertainty typically coincide with increased concerns about information asymmetries. Similarly, equity markets, as a whole, do not suffer from sharp reductions in liquidity as a result of increased uncertainty because the high levels of disclosure and considerable public analysis of stocks mean that uncertainty is less likely to result in higher perceived information asymmetries. However, even in equity markets, liquidity has recently declined more for stocks with small market capitalisation, for which there is typically less analysis and so potentially greater information asymmetries, than for large market capitalisation stocks (Figure 1).

A generalised increase in uncertainty can also cause liquidity problems through banks becoming markedly less willing to make new loans. This can occur if the increase in uncertainty triggers a reassessment by banks of their ability to raise funds in the future and the extent to which existing clients will call on lines of credit. In this environment, banks may themselves seek to increase their own holdings of liquid assets, as protection against this more uncertain world. This has the potential to generate self-perpetuating liquidity problems, with banks becoming reluctant to lend and withdrawing from financial markets.

3.3 Market Infrastructure

A third factor influencing liquidity is the underlying market infrastructure. Market design – involving how buyers and sellers interact to reveal their private information and how they settle their trades – can have a significant influence on how the market responds when conditions become strained. It is notable that in the current turmoil, dislocation has tended to be greater in the markets for financial assets and derivatives that trade in OTC markets and settle bilaterally.

Structured finance products and many derivatives typically trade OTC because of their inherent idiosyncratic features. Products trading in OTC markets can be tailored to the specific requirements of the counterparties and these markets are often more suitable for new and developing products. Therefore, it is no surprise that structured financial products and many derivatives typically trade in OTC markets.

At the heart of the recent turmoil has been an increase in perceived counterparty risk, related to a large extent to asymmetric information as discussed above. Since most derivatives that trade in OTC markets settle bilaterally, confidence in one's counterparty to meet all obligations is critical to the willingness to trade. This is particularly so for many long-lived derivatives – including credit derivatives – for which the relationship with a counterparty may last many years. Not surprisingly, heightened counterparty risk has led to a significant reduction in liquidity in many bilateral markets. Indeed, it is notable that liquidity in foreign exchange swap markets declined more at longer horizons where counterparty risk is greater.

Other aspects of OTC markets can also make them more susceptible to potential buyers or sellers remaining on the sidelines. Trading in competitive markets is often concentrated, either at a point in time or a particular location, because the more traders there are, the greater the odds that a buyer or seller can find a matching order and so trade at the market price. Because OTC markets can be more fragmented than exchange-traded markets, they may be more susceptible to a loss of liquidity – in essence there is an unwillingness to transact because it can be harder to locate buyers or sellers.

Lack of transaction transparency can also reduce the willingness to trade. If market participants cannot observe recent transaction prices, then, in a period of increased uncertainty or volatility, they may be less willing to trade for fear of trading away from the true market price. In general, OTC markets have lower transaction transparency than exchange markets.

One example of a market in which low transaction transparency appears to have hampered liquidity is the market for Australian residential mortgage-backed securities (RMBS). Unlike the case in the United States, Australian RMBS have not suffered a deterioration of fundamentals, with arrears and default rates remaining low. Yet in early 2008, large selling by offshore structured investment vehicles contributed to a substantial fall in the prices of Australian RMBS. In the following months, liquidity in the market was low as buyers continued to bid at the low prices at which ‘distressed’ sales had reportedly taken place, while sellers asked for higher prices on the basis that the distressed selling had abated. One factor contributing to wide bid/ask spreads was a lack of timely information about actual transaction prices.

3.4 The Need to Close Out Large Positions in a Short Period (Particularly After a Failure)

A fourth factor that can lead to liquidity problems is the failure, or near failure, of a large institution or investor. The news, and rumour, surrounding such an event can result in a sharp increase in uncertainty and perceived information asymmetries, thereby decreasing liquidity through the channels described above. Ordinarily, large investors build up or sell positions gradually so as to reduce the price impact that can result from large changes in their positions. However, in a time of stress, a large investor may not have the luxury of selling gradually in order to minimise the price impact. While an asset's price falling below its fundamental value might ordinarily provide opportunities for other traders, large price falls in one market can have significant ongoing adverse consequences for that market and related markets.

The feedback mechanisms largely result from the use of debt to fund positions in those markets. The fall in asset values means that investors are less able to obtain funding, because in effect their gearing has increased. The resulting margin calls require further asset sales to repay debt, causing further price falls. Brunnermeier (forthcoming) has termed this mechanism a ‘loss spiral’, with Brunnermeier and Pedersen (forthcoming) presenting an additional ‘margin spiral’ channel that compounds the loss spiral. They argue that lending standards tighten when prices fall, so that margins increase. This reduction in funding liquidity results in additional asset sales and further price falls. Furthermore, the price fall in one market can spill over to other markets. If price falls lead to a general tightening of lending standards then the ‘margin spiral’ will spread to other markets. Similarly, investors may sell other assets to meet margin calls or redemptions because liquidity in the market with the initial price falls has declined and so the ‘loss spiral’ will spread.

Given the prevalence of borrowing to fund positions and use of margins to provide security for these loans it is difficult to avoid loss spirals and margin spirals, particularly in the case of the failure of a large investor. Hence it is important to attempt to minimise their impact by providing a market framework that reduces information asymmetries and uncertainty, thereby lessening any decline in liquidity.

3.5 Summarising Reasons for Illiquidity

The existence of asymmetric information and increases in uncertainty are central to explaining illiquidity in asset markets. As described in the paper so far, these factors alone are sufficient to hamper the development of liquid markets, or cause liquid markets to become illiquid. But their interaction with inadequate market infrastructure or one-sided markets following the failure of a large participant can result in severe illiquidity across many asset markets. In the following sections we consider measures that have been used, or could be used, to make liquidity in financial markets more resilient to these problems. One possibility is the promotion of financial infrastructure that reduces information asymmetries. But, acknowledging that these initiatives may not always be successful or be possible, we then consider how to mitigate the impact of shocks that would reduce liquidity, either through financial institutions holding more liquid assets or the public sector providing liquidity services.