The Financial Stability Board has outlined policies to improve the resilience of liquidity access in stress conditions, which include widening the use of central clearing for government bond repo and cash market transactions and encouraging participation of new non-bank intermediaries through “all-to-all” trading platforms.
The policy recommendations are published in a new FSB report on Liquidity in Core Government Bond Markets, released today, which has grown from a broader project to boost the resilience of non-bank financial intermediation (NBFI).
The report notes that core government bond markets experienced severe dislocations during the March 2020 ‘dash for cash’ as investors sold off highly liquid assets to meet their cash requirements, whether this was to meet margin calls, to fulfil redemptions by fundholders, to unwind leveraged positions, or for other liquidity needs.
Rather than providing a safe haven during times of market instability, the FSB proposes that changes in government bond markets over the past 10 years may have made them increasingly vulnerable to liquidity imbalances under stress conditions.
While bank dealers did step forward to increase their trading as the ‘dash for cash’ gathered momentum, the FSB concludes that this was not enough on its own to meet selling pressures and, in many cases, other liquidity providers did not increase their intermediation activities to meet this demand.
The FSB notes that central bank interventions were effective in reacting to these market strains, but central bank liquidity support should not be a substitute for market participants’ ability to respond to these liquidity imbalances and to manage their own risks appropriately.
With this in mind, the report proposes measures to strengthen responses by non-bank intermediaries to unexpected and sizeable spikes in liquidity demand.
This should be accompanied by steps to improve risk monitoring, market oversight and the readiness of financial authorities and market participants to respond to liquidity imbalances during times of market stress. This should include measures to improve the transparency of government bond markets and to close substantial data gaps identified by the report.
In this respect, its recommendations include a need for more detailed information on the activities of principal-trading firms and greater transparency relating to the identity of participants active in the bilateral repo market.
These considerations become particularly relevant, the report notes, as a result of the sharp rise in the size of the core government bond markets over the past decade. In the US, outstanding government debt has grown from approximately US$13.6 trillion in 2010 to US$25 trillion in 2020, a rise from 90 to 130 per cent of US GDP.
Over the equivalent period, government debt in the euro area has grown from €8.3 trillion to €12.9 trillion, rising from 87 to 113 per cent of euro area GDP. In the UK, the government debt-to-GBP ratio has climbed from 80 to 137 per cent, with outstanding government debt rising from £1.3 trillion to £2.9 trillion.
This report builds on the FSB’s framework for improving NBFI resilience, including money-market funds, that was published in Q4 2021 and evaluated previously in Securities Finance Times.
The FSB indicates that it is important to explore ways to extend the use of central clearing for government bond cash market transactions, and particularly for repo trades, given the balance sheet relief that CCP clearing can afford in this segment. This said, the report recognises that central clearing may increase cost for market participants over bilateral arrangements and, therefore, in some cases there is little incentive for market participants to shift flow to central clearing unless this is mandated.
The report also reviews the potential benefit of “all-to-all” trading platforms that could encourage new non-bank intermediaries to the repo and government bond cash markets, complementing the activities of traditional dealers in supporting liquidity provision. This could provide investors with wider access to market liquidity without needing to rely heavily on dealer intermediation.
The test will be whether a new community of non-bank intermediaries will be a resilient source of liquidity provision during stress conditions — and that is still to be proven.
