RMA: Periods of air pockets and illiquidity is here to stay
14 October 2022 RMA Conference 2022
Image: Shutterstock
Inflation, global instability and rising rates have resulted in nervousness throughout funding and cash markets. A morning panel on day two of the Risk Management Association’s (RMA) 37th Securities Finance & Collateral Management Conference discussed why market liquidity in the treasury market has been poor.
A panellist said it is fundamentally rooted in macro economic uncertainty, in addition to being punctuated by an increased amount of investor risk aversion, and a weak treasury demand backdrop at present. Other asset classes have been seen to underperform. Due to the uncertainty, market participants are afraid to “catch the falling knife”.
From a securities lending and cash reinvestment standpoint, clients are showing interest in strategies, eager to get back into programmes and tweaking these programmes to increase some risk in their cash guidelines, according to one panellist.
The industry has started to recognise that the market, including the cash market, has fundamentally changed. Clients are also recognising where there are good opportunities to loan general collateral and take advantage of that without adding risk to their portfolios.
Moving the discussion toward balance sheet, a panellist stated that the Federal Reserve System balance sheet had doubled in size since pre COVID-19. In response, one panellist explained that the balance sheet was expanded rapidly to support market functioning, but now the Fed is engaged in the process where they are trying to shrink that — otherwise known as quantitative tightening (QT).
The Fed is worried that the balance sheet is abnormally large and, as a result, may create distortions in the financial markets that are difficult to anticipate and that can lead to financial instability risks in the future.
A panellist highlighted that as the Fed drains liquidity from the system, as the organisation shrinks the size of their balance sheet, it will be drained from either bank reserves or the Overnight Reverse Repo Facility (ON RRP). Currently, it is all being drained from the bank reserves.
The panel also discussed liquidity concerns in the market. It appeared, from a broader treasury perspective, that the market is fragile and liquidity is thin. A concern for the panel was the idea that the treasury market could be one shock away from experiencing pronounced air pockets, where the demand is not there.
Some firms have been clear with their clients on the need to be ready for periods of total illiquidity. A panellist said that conversations with clients consisted of preparing them for air pockets and trying to immunise their portfolio to weather the air pockets by being able to survive a couple of days without liquidity in the market. They concluded that periods of air pockets and illiquidity are here to stay.
A panellist said it is fundamentally rooted in macro economic uncertainty, in addition to being punctuated by an increased amount of investor risk aversion, and a weak treasury demand backdrop at present. Other asset classes have been seen to underperform. Due to the uncertainty, market participants are afraid to “catch the falling knife”.
From a securities lending and cash reinvestment standpoint, clients are showing interest in strategies, eager to get back into programmes and tweaking these programmes to increase some risk in their cash guidelines, according to one panellist.
The industry has started to recognise that the market, including the cash market, has fundamentally changed. Clients are also recognising where there are good opportunities to loan general collateral and take advantage of that without adding risk to their portfolios.
Moving the discussion toward balance sheet, a panellist stated that the Federal Reserve System balance sheet had doubled in size since pre COVID-19. In response, one panellist explained that the balance sheet was expanded rapidly to support market functioning, but now the Fed is engaged in the process where they are trying to shrink that — otherwise known as quantitative tightening (QT).
The Fed is worried that the balance sheet is abnormally large and, as a result, may create distortions in the financial markets that are difficult to anticipate and that can lead to financial instability risks in the future.
A panellist highlighted that as the Fed drains liquidity from the system, as the organisation shrinks the size of their balance sheet, it will be drained from either bank reserves or the Overnight Reverse Repo Facility (ON RRP). Currently, it is all being drained from the bank reserves.
The panel also discussed liquidity concerns in the market. It appeared, from a broader treasury perspective, that the market is fragile and liquidity is thin. A concern for the panel was the idea that the treasury market could be one shock away from experiencing pronounced air pockets, where the demand is not there.
Some firms have been clear with their clients on the need to be ready for periods of total illiquidity. A panellist said that conversations with clients consisted of preparing them for air pockets and trying to immunise their portfolio to weather the air pockets by being able to survive a couple of days without liquidity in the market. They concluded that periods of air pockets and illiquidity are here to stay.
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