Changing nature of liquidity risk may amplify market shocks, says ESMA
10 February 2023 EU
Image: AdobeStock/Ricochet64
High levels of uncertainty and fragile market liquidity are limiting the resilience of the financial system against external shocks, the European Securities and Markets Authority (ESMA) finds in its latest report on Trends, Risks and Vulnerabilities.
Recent stresses linked to liability-driven investment (LDIs) strategies that invest in GBP-denominated government bonds illustrate how quickly these risks can crystallise, notes the EU securities markets regulator.
A sharp rise in gilt yields in late September and early October, in the wake of the UK mini budget, accentuated liquidity pressures on heavily leveraged LDI funds. Margin requests surged on repo transactions collateralised by government bonds and interest-rate derivatives (IRDs).
LDIs attempted to sell sovereign bonds in their search for liquidity but, according to ESMA, the market was unable to absorb this volume of bond sales, prompting the Bank of England to intervene to support the sovereign bond market via a targeted short-term asset purchase programme.
With these developments, ESMA indicates that its systemic stress indicator, a refinement of the ECB composite indicator of systemic stress, has hit levels higher than those witnessed during the pandemic, particularly owing to these high volatility levels in EU sovereign and corporate bond markets.
In commodity derivatives markets, ESMA finds that the sharp rise in energy derivatives prices observed on the back of the Russian invasion of Ukraine, and the associated increase in margin requirements on exchange-traded derivatives (ETDs), has driven a migration of derivatives trades to non-cleared OTC markets, especially for non-financial corporates (NFCs).
For commodity trading firms, this represents a move to reduce their initial margin and variation margin commitments on cleared ETDs by stepping up their trading through OTC channels, where they may be able to negotiate less restrictive collateral arrangements, particularly for firms with a strong credit rating.
According to ESMA data, NFC exposures to OTC energy derivatives immediately prior to the Russian invasion of Ukraine represented approximately 15 per cent of outstanding gross notional amounts. However, this rose to around 25 per cent with the onset of conflict and had grown to almost 40 per cent of gross exposures by the end of December 2022.
ESMA concludes that this migration from ETD to OTC presents risks for the market. OTC markets typically offer lower liquidity than their ETD counterparts, it notes, and do not offer the price discovery, and levels of pricing transparency, delivered by lit markets. Moreover, uncleared trades, by definition, do not benefit from the centralised risk management offered by a central counterparty.
More broadly, ESMA notes that a wider range of structural developments over the last decade have increased the potential for liquidity risk in times of stress.
One is the liquidity mismatch confronting open-ended investment funds, which may offer daily liquidity to their investors but may be invested in relatively illiquid instruments that may be difficult to sell under stress conditions. In these circumstances, the funds may struggle to meet redemptions from unit holders in conditions of high volatility, such as those witnessed when the pandemic took a grip in Europe in March 2020.
Second, while the promotion of central clearing for derivatives transactions has lowered financial stability risk, this has potentially increased liquidity risk for the reasons outlined.
Developing this point, ESMA notes that liquidity supply has changed significantly over the past decade.
The shift by some banks from a dealer-based model of liquidity provision to a broker-based model — where banks, according to ESMA, act more like “pass-through agents” — has changed the mechanisms through which liquidity is supplied to the market. Wider use of electronic trading has also enabled proprietary-trading firms to become dominant participants in liquid markets.
In stress conditions — or even in the run up to periodic reporting deadlines — liquidity suppliers may be reluctant to provide liquidity owing to balance sheet constraints or because they have a lower appetite for risk.
The overall outcome, says the Authority, is that in current conditions of financial uncertainty market shocks may be magnified by imbalances in liquidity supply and demand.
Recent stresses linked to liability-driven investment (LDIs) strategies that invest in GBP-denominated government bonds illustrate how quickly these risks can crystallise, notes the EU securities markets regulator.
A sharp rise in gilt yields in late September and early October, in the wake of the UK mini budget, accentuated liquidity pressures on heavily leveraged LDI funds. Margin requests surged on repo transactions collateralised by government bonds and interest-rate derivatives (IRDs).
LDIs attempted to sell sovereign bonds in their search for liquidity but, according to ESMA, the market was unable to absorb this volume of bond sales, prompting the Bank of England to intervene to support the sovereign bond market via a targeted short-term asset purchase programme.
With these developments, ESMA indicates that its systemic stress indicator, a refinement of the ECB composite indicator of systemic stress, has hit levels higher than those witnessed during the pandemic, particularly owing to these high volatility levels in EU sovereign and corporate bond markets.
In commodity derivatives markets, ESMA finds that the sharp rise in energy derivatives prices observed on the back of the Russian invasion of Ukraine, and the associated increase in margin requirements on exchange-traded derivatives (ETDs), has driven a migration of derivatives trades to non-cleared OTC markets, especially for non-financial corporates (NFCs).
For commodity trading firms, this represents a move to reduce their initial margin and variation margin commitments on cleared ETDs by stepping up their trading through OTC channels, where they may be able to negotiate less restrictive collateral arrangements, particularly for firms with a strong credit rating.
According to ESMA data, NFC exposures to OTC energy derivatives immediately prior to the Russian invasion of Ukraine represented approximately 15 per cent of outstanding gross notional amounts. However, this rose to around 25 per cent with the onset of conflict and had grown to almost 40 per cent of gross exposures by the end of December 2022.
ESMA concludes that this migration from ETD to OTC presents risks for the market. OTC markets typically offer lower liquidity than their ETD counterparts, it notes, and do not offer the price discovery, and levels of pricing transparency, delivered by lit markets. Moreover, uncleared trades, by definition, do not benefit from the centralised risk management offered by a central counterparty.
More broadly, ESMA notes that a wider range of structural developments over the last decade have increased the potential for liquidity risk in times of stress.
One is the liquidity mismatch confronting open-ended investment funds, which may offer daily liquidity to their investors but may be invested in relatively illiquid instruments that may be difficult to sell under stress conditions. In these circumstances, the funds may struggle to meet redemptions from unit holders in conditions of high volatility, such as those witnessed when the pandemic took a grip in Europe in March 2020.
Second, while the promotion of central clearing for derivatives transactions has lowered financial stability risk, this has potentially increased liquidity risk for the reasons outlined.
Developing this point, ESMA notes that liquidity supply has changed significantly over the past decade.
The shift by some banks from a dealer-based model of liquidity provision to a broker-based model — where banks, according to ESMA, act more like “pass-through agents” — has changed the mechanisms through which liquidity is supplied to the market. Wider use of electronic trading has also enabled proprietary-trading firms to become dominant participants in liquid markets.
In stress conditions — or even in the run up to periodic reporting deadlines — liquidity suppliers may be reluctant to provide liquidity owing to balance sheet constraints or because they have a lower appetite for risk.
The overall outcome, says the Authority, is that in current conditions of financial uncertainty market shocks may be magnified by imbalances in liquidity supply and demand.
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