IOSCO Analyzes Liquidity in Corporate Bond Market under Stressed Conditions

Steven Lofchie Commentary by Steven Lofchie

IOSCO analyzed how stress conditions would impact liquidity in secondary corporate bond markets.

In a report prepared by the IOSCO Committee on Emerging Risks, IOSCO found that changes to market intermediaries and in supply/demand patterns for corporate bonds have caused the structure of the corporate bond market to change significantly since the financial crisis. IOSCO highlighted several changes, including the following:

  • fewer broker-dealers are willing to participate as principals, which could make future movements in bond prices more acute in stressed conditions; and

  • there is a higher unlikelihood of mutual funds serving as a "source of either considerable selling or price volatility under stress."

IOSCO also asserted that it expects a reduced risk of strong price movements in bond markets leading to broader economic stress. Specifically, IOSCO attributed this change to:

  • more effective liquidity management by the issuers of corporate debt;

  • reduced leverage and fewer leveraged players than before the financial crisis; and

  • a lower frequency of corporations entering primary bond markets for financing.

IOSCO warned that corporate bond markets' response to stress will be significantly influenced by the commitment of market participants to "provide sufficient demand-side liquidity to help stabilize markets." As to regulatory matters, the report noted that while IOSCO has not examined whether the impact of post-crisis regulations on the resilience of the banking system, "post-crisis financial reforms may have curtailed the ability of intermediaries to provide liquidity to their clients."

Commentary

It is not clear what incentive market participants would have to provide liquidity that will help to stabilize markets. Historically, market makers were compensated (arguably overcompensated) for serving in that role; thus the threat of losing the right to serve in that role could serve as an incentive to provide liquidity to a declining market. Regulations have generally removed the benefits of serving in a market maker role, so it is not obvious why any firm would or should put itself at any material financial risk to stabilize the markets.

This is not to say that it was a mistake to deprive market makers of the compensation that they obtained from serving in that role. Regulators simply have to acknowledge that there is a trade-off: if there is no reward, there is no reason to take risk.

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