Box B: Implications of global liquidity developments for New Zealand
This page contains information on the implications of global liquidity development for New Zealand from the November 2015 Financial Stability Report.
Over the past year there have been events in which market liquidity has declined suddenly, and there are growing concerns internationally that there may have been a structural change in the provision of market liquidity.1 A liquid market is one where large transactions can be executed with only a limited effect on the price of an asset. Market liquidity is important for the functioning of financial markets, helping to facilitate the efficient distribution of resources through the allocation of capital and risk at low cost. Market liquidity also supports financial stability, as prices are more likely to remain aligned with fundamentals.
Several events have served to crystallise some of the concerns related to lower market liquidity, including the October 2014 US Treasury bond ‘flash rally’, the April 2015 ‘Bund (German government bonds) tantrum’ and recent market turbulence tied to concerns around Chinese growth. There has also been evidence of diminished liquidity in currency markets, as evidenced by the rapid moves in the NZD/USD cross rate on 25 August. The rate fell as much as three US cents over 10 minutes before quickly rebounding (figure B1). The by-product of lower liquidity has been increased difficulty in executing trades, higher costs and higher volatility in some markets.
Figure B1: NZD/USD cross rate (New Zealand local time)
Several factors could explain lower liquidity in some markets. One important factor is reduced ‘market-making’ activity by financial institutions. Market makers play a key role in providing liquidity by quoting two-way prices to participants in over-the-counter markets (those not run on exchanges). As part of this role, market makers take on risk by holding inventories of the assets they offer to buy or sell. However, since the GFC a combination of a reduction in risk appetite of market makers, and increased regulatory burdens (such as increased capital requirements in Basel III rules) has resulted in less willingness to provide such market making services.
While a reduction in market making has been significant, other factors have been acting on market liquidity, both positive and negative. More generally, global liquidity has been supported by the extraordinarily easy monetary policy settings currently in place by major central banks. In some markets, liquidity has been enhanced by central banks acting directly as market makers or facilitating market activities through securities lending. In addition, many central banks have become a predictable, large buyer of government bonds, which has in turn caused investors to seek returns in other markets (e.g. more risky corporate bonds), improving liquidity there. On the other hand, liquidity in some bond markets has been reduced by central banks holding significant proportions of outstanding bonds and not turning the stock over as frequently as other market participants.
There are three key channels through which New Zealand could be affected by declining market liquidity: the impact on New Zealand banks’ funding markets; the impact on short-term interest rates and monetary policy implementation; and the impact on the New Zealand government bond market.
New Zealand banks fund a significant proportion of their balance sheets by accessing offshore wholesale debt markets. They do this by borrowing in foreign currency, then ‘swapping’ this back into NZD. Conditions in global financial markets are therefore an important determinant of New Zealand bank funding. New Zealand banks tend to focus on the primary market (new issues) rather than the secondary market for debt. Hence, funding liquidity is of more immediate importance than market liquidity. Funding liquidity refers to the ability of the banks to raise debt as required at a reasonable cost. Reserve Bank discussions with bank treasurers suggest that funding liquidity conditions have deteriorated somewhat in 2015, owing largely to greater market volatility caused by events such as the Greek crisis mid-year and recent turbulence tied to China.
New Zealand banks typically use market makers to help facilitate the foreign currency swap leg involved in borrowing from offshore. Market makers take the other side of the transaction with New Zealand banks (providing NZD in exchange for foreign currency that the banks have raised), while charging a spread. This spread has widened as costs have increased for the institutions providing these market making services for the reasons described above. Overall, the cost increases have been manageable thus far, but this highlights the flow-on effects of changes in market liquidity to New Zealand entities seeking offshore funding.
Fewer market makers in the foreign exchange swap market and lower risk appetite among banks have also led to increased volatility in shortterm money markets. This can affect the transmission of monetary policy, with interest rates potentially deviating away from the Official Cash Rate (OCR). The Reserve Bank has responded to this by increasing its participation in the market through open market operations and foreign exchange swaps, which have helped to keep key short-term interest rates in line with the OCR.
The New Zealand government bond market has always been seen as relatively illiquid given its small size in comparison with other sovereign debt markets. Discussions with market participants suggest that liquidity improved significantly following the GFC as issuance rose and new investors were attracted to holding New Zealand sovereign debt. Most investors trading in small parcels of bonds report that they have been able to trade as normal, with domestic market makers able to absorb the risk on their balance sheets. However, some foreign-based market makers have started to reduce their participation in the New Zealand market owing to more generalised global pressures on their market making business model. There are increased risks that over time the higher costs that market makers are facing are passed on to end users through wider spreads offered to clients.
The Reserve Bank will continue to closely monitor developments in liquidity and its effects on the New Zealand financial system.
1See, for example, BIS (2014) ‘Market-making and proprietary trading: industry trends, drivers and policy implications’, CGFS Papers, No. 52, November; and IMF (2015) ‘Chapter 2: Market liquidity – Resilient or fleeting?’, Global Financial Stability Report, October.