Sovereign debt crisis hits liquidity

With volatility returning on the back of the sovereign debt crisis in Europe, liquidity remains a concern for credit investors. Markit’s Gavan Nolan outlines how liquidity can best be measured, and how it has been affected by recent events.

Think back to the heady days of 2006 and recall what issues were preoccupying the financial markets. At the time, there seemed to be no limit to the ambition of the private equity industry, while credit investors were struggling to find attractive yields with the Markit iTraxx Europe index at 25 basis points.

Some shrewder market participants may have wondered about suspect securitisation practices, global economic imbalances and the ramping up of leverage in the financial system. But liquidity was certainly not a favourite topic of the commentariat.

Fast forward four years, and much has changed. It is now widely accepted that liquidity played a central role in the credit crisis of 2007 and the subsequent global recession. The trade and mainstream press now mention the term “liquidity” with unceasing regularity, and liquidity risk can no longer be ignored as it was in the recent past.

However, liquidity is still one of the least understood areas of finance. Unlike the more established disciplines of market and credit risk, liquidity has not been the subject of considerable capital investment – both human and technological – and lacks the intellectual framework that inevitably accumulates after years of study. In particular, coherent methods of measuring liquidity in the credit markets have been in short supply.

What is liquidity?

Before we look at the methods of measurement, some definitions are required. There are several different types of liquidity, and the term can be somewhat confusing to the uninitiated.

Funding liquidity, as defined by the European Central Bank, is the ability to settle obligations immediately when due. Banks, due to their reliance on the money markets, are particularly exposed to funding risk. Central banks act as the lender of last resort when banks are unable to fund independently, with the ECB assuming this role for European banks since 2009.

Market liquidity refers to an asset’s ability to be sold without causing a significant movement in the price. An investor should be able to exit a position within a set timeframe at a level close to the market price. The main factor determining liquidity is market depth, which is reflected by the number of dealers making markets. A market participant will clearly find it harder to exit a position on an instrument that has only three active market-makers compared with an instrument with 15. This was the case with some of the opaque structured credit products that helped precipitate the credit crunch. Depth was also affected by the collapse of several major dealers, such as Lehman Brothers and Bear Stearns.

Another factor to be considered is bid/ask spreads: the tighter the spread, the more liquid the product. To some extent this is a corollary of depth: if there is more competition in market-making, then the spread will tighten.

How do we measure liquidity?

Market liquidity is of most interest to many industry participants, and perhaps the best way to demonstrate liquidity measurement is to look at some examples.

CDS liquidity

Sovereign credit risk is currently among the most important issues facing the global economy. Governments in many countries have accumulated unsustainable fiscal deficits, and concern over their ability to repay their debts has been one of the key drivers of recent market volatility. Greece, in particular, has been at the heart of the sovereign debt crisis: its credit standing has come under severe scrutiny, forcing it to seek help from its fellow Eurozone members and the International Monetary Fund. The country’s credit default swap spreads have widened dramatically over the last six months; with chart 1 showing that its five-year CDS spreads at certain points even breached the 1000bp mark.

Nevertheless, some commentators have questioned how liquid the sovereign CDS market is; and, on that basis, have asked whether the record spreads for Greece are reflective of the underlying risks. The chart above shows the average bid/ask spread – a key liquidity metric – for Greece’s CDS level. It reveals the bid/ask spread widened dramatically in late April, when Greece was under intense pressure, which indicates there was a diminution in liquidity during this period. But the chart also shows that the bid/ask spread has come down subsequently, fluctuating around the 40–50bp level. This is during a period when the CDS spread has widened.

Another important metric, market depth, has stayed robust. Markit’s figures show that between 10 to 14 dealers are regularly making markets in Greek sovereign CDS. Markit’s liquidity score, which takes into account bid/ask spreads, market depth and freshness of data contributions, shows Greece has a score of one, indicating high market liquidity. But the metrics also show the number of quotes sent through Markit’s parsing system declined in June compared with previous months. This could be a consequence of the flood of news headlines on Greece dissipating to some extent.

Bond market liquidity

Many of the same metrics in CDS liquidity can be applied to bonds. Oil giant BP has been much in the news recently, with its role in the oil spill in the Gulf of Mexico causing it considerable problems. The company’s CDS spreads started to widen not long after the spill came to light in April, with its bond prices reacting later.

Chart 2 shows a steep decline in liquidity starting in late May for the 4% bond maturing in 2014. The bid/ask spreads showed signs of increasing a little earlier, but really started to widen in early June in tandem with the precipitous fall in the bond price. There was a short period of considerable volatility before the bid/ask spread settled around 1.2% in mid-June, significantly higher than before BP’s credit standing worsened.

This suggests liquidity in BP’s bonds has been impaired, but it is important to look at other liquidity metrics and not just the bid/ask spread in isolation. Markit’s depth count shows that while the depth of the market in BP bonds did take a hit in May and early June – the same time as the increased volatility in bid/ask spreads – it has since recovered to levels not far off pre-oil spill levels. Indeed, the high market depth means that the bond has a Markit liquidity score of one. This is consistent with the stabilisation of the bid/ask spread during the second half of June.

The importance of liquidity metrics

One of the principal causes of the global recession we are slowly emerging from was excess debt in the financial system, for which CDS, bonds and loans are the barometers of credit risk. But if investors and regulators are to have confidence in the pricing of instruments in the secondary market, they need to have an accurate measure of liquidity. Financial markets have been afflicted by an information vacuum in this area, a vacuum that liquidity metrics go some way towards filling.

Gavan Nolan is a credit analyst at Markit.