Liquidity in a crisis: Comparing the credit market response in 2020 and 2008
The fast and adaptive market response that greeted the coronavirus shock last year showed how much the financial system has improved since the credit market liquidity issues of the global financial crisis.
Back in 2008 we saw a wake-up call for the industry’s ability to handle a potential liquidity crunch. How well markets listened to that call was put to the test in 2020 when COVID-19 threw the world into turmoil. And the industry demonstrated that lessons were learned – that the market has evolved.
Governments’ “whatever-it-takes” approaches to asset purchase programmes played a vital role in ensuring that a liquidity crisis did not turn into an insolvency crisis. But there were a number of other advancements over the past decade that also put us in a far better position than in 2008.
While the market evolves, so too does demand. As investors such as defined benefit (DB) pension schemes enter the next phase of their journey, and move a stage closer to end game, a requirement to take further risk off the table has led to the pursuit of assets which provide contractual and more certain income streams.
With more investors chasing a constrained pool of high-quality assets, the ability to source these opportunities at the right price and through a multitude of channels, will be key to investors achieving their long-term goals.
Risk appetite, the market and algorithms
In a crisis, risk appetites may sometimes come down to one-word – conviction. Sellers or buyers with risk-on or risk-off appetite can fuel liquidity. New avenues to liquidity in 2020, as well as quantitative easing measures of a type not seen in 2008, helped to give confidence to sellers and buyers.
The bid/offer spread – the difference between the seller’s asking price and the price a buyer is willing to pay in the secondary market – widened quickly during the 2020 crisis as both sides looked to reduce risk, but it also quickly returned quickly to normal. In 2008 this took far longer as the market’s appetite for risk was shaken, severely limiting liquidity.
The technology used in trading is far more sophisticated now which is good news for investors looking to access liquidity quickly. Open trading or liquidity-matching engines did not exist in the same way in 2008, with no peer-to-peer mechanism for sourcing liquidity outside of bank balance sheets except through brokers.
In 2020 these platforms, which were not monitored much during 2008, were extensively used and saw record months as investors sought dynamic ways to interact with each other to avoid wider bid/offer spreads. On one day, through one platform, we saw the equivalent of $25bn peer-to-peer trading without the need for using bank balance sheets1 .
Bank balance sheets and ALPs
Bank balance sheets have declined since 2008, affecting the amount of risk banks are willing to take on. As a result, dealer inventory has fallen while the size of mutual fund assets, exchange traded fund (ETF) holdings and pension fund mandates has grown significantly.
Bigger bank balance sheets in 2008 maxed out inventory, leaving banks unable to take on more bonds in a de-risking market, so at times liquidity simply disappeared. But in 2020, guarded balance sheets could be used to take advantage of significantly widened spreads.
It remains important to maintain strong relationships with all the banking market makers. They still represent significant turnover. But at times this route can encounter difficulties in volatile environments or during single direction momentum. To address potential liquidity issues, we now have greater access to alternate liquidity providers (ALPs).
ALPs initially worked in the ETF space in creations and redemption but have now pivoted towards market making, portfolio trading and opening up access to ETFs. They have proven very useful at times for providing liquidity when banks have been costlier, and in the heat of the coronavirus crisis many companies used these providers to allow more efficient access to liquidity.
Axes is a term used for the interest a trader has in buying or selling a security. Having the tools to know traders’ axes is key to gaining a liquidity advantage.
Communication on axes was very primitive in 2008. Now, most traders have sophisticated data systems which make up the core of intelligence gathering processes, which enables peer-to-peer buying and selling as the main source of liquidity.
Fundamentally, the peer-to-peer world is much more connected thanks to innovations in new technologies to give these trades a platform to take place.
At AXA IM we have developed our Axes and Pricer system which allows us to tap into liquidity much more effectively, by gathering data that builds a detailed picture of where the market is heading. Using these systems, we are able to process about 95% of trades on the same day. Over the whole of 2020, for trades executed on our London desk, we saved an average of €0.34 per trade as measured by our Transaction Cost Analysis, or €0.28 when excluding outliers in the data.2
ETF and portfolio trading
ETF redemption and creation around the time of the 2008 crisis was not anywhere near the levels we saw last year. Creating a basket of securities that can be exchanged for an ETF helps fixed income traders take advantage of continuous transactions to access liquidity fast. Large redemptions in March 2020, as the pandemic took hold, helped buyers to source high quality bonds in this way, which was unavailable during the 2008 crisis. The downside to this is that sales created a lot of uncertainty and market repricing.
Portfolio trading was similarly not heard of much around 2008, and has only really become common in the past five years or so. The immediacy and certainty of accessing large blocks of bonds was a considerable help to us in accessing liquidity, particularly in the more difficult months of 2020.
Central bank intervention
Quantitative easing offered a new wrinkle to the crisis response as we didn’t see the same kind of government interest in corporate bonds in 2008 as we saw during 2020. This has no doubt helped prevent similar levels of defaults and is likely to be the model which any potential future financial crisis would follow.
Corporate bond purchase schemes do, however, take bonds out of the market. Where there are supply constraints, such as in sterling credit, that can have the effect of tightening spreads and lead to more expensive liquidity. Perhaps a feature to watch for when the next crisis rolls around.
Looking back at 2020, and the changes that allowed us to chart a course through choppy markets, we have seen a series of enhancements that appeared to soften the damaging effects of the pandemic. In 2021, we may be looking ahead to a route out of the crisis, but we believe those same tools are still offering credit investors a potentially better way to manage the unpredictable.
An earlier version of this article originally appeared in Professional Pensions.