“The bid/offer spread on a screen is often not even close to where an asset will transact,” according to John Taylor, senior portfolio manager, fixed income investments at AllianceBernstein. “Normally an investment grade name could have a five basis point bid/offer spread for trades within $1m, but if you want to trade at $10m that can widen to 10 basis points or more,” he says.
Axa Investment Managers’ head of FX and fixed income dealing, Lee Sanders, says on-screen quoted bids and offers are “no longer the main source of price discovery”.
He says: “As soon as you get beyond the quote depth, you enter a completely different market. Prices involve more of a fishing technique these days now that banks are holding less inventory.”
The bid/ask spread is also only useful for the most liquid instruments. The more illiquid an asset is, the greater the need for accurate measurement, but the greater the intrinsic error associated with using the bid/ask spread as a measure of liquidity.
These proxies play an important role in the general understanding by the investment community of the level of liquidity available to the market as a whole and, by extension, of the risks associated with their portfolio holdings.
MORE OR LESS LIQUIDITY?
The debate about whether or not market liquidity has materially changed since the financial crisis has reignited recently with a growing number of suggestions that illiquidity is not necessarily on the rise.
The Financial Conduct Authority (FCA), in its Occasional Paper No. 14: Liquidity in the UK corporate bond market: evidence from trade data, concludes that despite warnings of liquidity falls becoming commonplace, analysis of transaction data suggests a “more positive picture”. The paper points to the absence of any decisively accurate measures of liquidity and the reliance on “useful, but limited proxy measures” as part of what is fuelling the pessimism, but also points out that UK dealers’ corporate bond inventories fell nearly 40% from £400bn in mid-2008 to just £250bn at the end of 2014.
However, the FCA paper finds: “Aside from a relatively brief period immediately after the crisis, illiquidity has been decreasing to very low levels. Roundtrip costs – a reliable indicator of liquidity – had declined from a peak of around 0.5% in 2009, to 0.1% at the end of 2014.”
Imputed roundtrip costs, a key measure used in the FCA’s analysis, measure the price differential a trader would receive over a full cycle of buying and re-selling (or selling and re-buying) a given asset over a given period of time. For example, data from Trace in the US shows around 20% of all trades relate to bonds that trade two or more times very quickly after a longer period without any trading. Where this cluster of trades occurs, the prices on both sides of the trade can be used to identify roundtrip trading and the trade prices analysed to provide a measure of roundtrip costs. The imputed roundtrip cost is a proxy for the realised bid/ask spread.
MURKY WATERS
While using imputed roundtrip cost goes some way to addressing the failings of the quoted bid/ask spread as a liquidity proxy, it is not without its own shortcomings. Sommer and Pasquali, among others, dispute the usefulness of imputed roundtrip costs, citing lack of data as a key failing.
The FCA’s databank is naturally very large given its role as the national authority and the regulatory reporting obligations. However, this is still inherently skewed to the most liquid end of the market.
If a trader can’t get a deal done, that doesn’t throw up any regulatory reporting requirements and thus, analysis of the regulator’s data will completely miss out a very large and growing proportion of the market that is proving illiquid simply because there is no data generated by intended, but unrealised trading. Thus the usefulness of imputed roundtrip costs is severely undermined.
“You can’t measure liquidity by what trades are going on,” argues Cai Rees, client investment strategist at SEI. “Two out of three trades can’t be made because the market is not there. No one gets to see the trades that don’t happen. Traders are having to pass on more trades today versus a couple of years ago and that gets a little worse every time another bank pulls out of the market.”
A measure using realised bid/ask spreads is also retrospective, as the FCA points out in its report: “While liquidity in the past is a comfort, it is not a guarantee of its presence in the future. When everyone is rushing from a crowded room for the same exit doors, crushes ensue.”
