Mastering Flows, Strengthening Markets: How sovereign institutions can enhance global liquidity | October 2016
This Official Monetary and Financial Institutions Forum (OMFIF) - BNY Mellon report focuses on the role that sovereign institutions may have to play in improving overall market liquidity, and contains results of OMFIF’s survey of 25 sovereigns with over $4.7 trillion AUM.
Hani Kablawi, CEO of EMEA Investment Services at BNY Mellon
Having entered a period of almost unparalleled change for the global financial community with political and economic uncertainty challenging investor confidence, it is perhaps counterintuitive to suggest that opportunities abound for members of the sovereign community. It would be more radical still to suggest that the benefits to the broader financial system that would accrue are central to the continued well-being of that system.
Historically, sovereigns have invested in high quality liquid assets (HQLA) such as government bonds and main index equities as core holdings in their conservatively-managed portfolios. In the aftermath of the financial crises of the 1980s and 1990s, central banks in emerging markets began to accumulate substantial amounts of such assets, becoming one of the largest owners of HQLA, particularly G7 government bonds. As interest rates in economies of these issuers entered a steady downward trajectory, these assets proved to be good investments, and critical to the defense of their currencies and economies, helping to avoid capital flight when the next crisis arrived in 2007.
Quantitative easing across major economies has, however, seen the likes of the Federal Reserve, European Central Bank, Bank of Japan and Swiss National Bank collectively leap-frog their emerging market peers as the largest holders of their own and other developed markets’ HQLA, including sovereign debt, equity indexes and blue chip corporate obligations. This hoarding of HQLA by central banks, eager to pump liquidity themselves, has had a significant ‘crowding-out’ effect, further straining primary and secondary market activity in these asset classes.
As demand has pushed down interest rates to ultra-low or even negative territory, sovereign investors have joined others in the hunt for yield, making higher allocations to riskier asset classes, carrying with them a heightened risk of illiquidity when monetary conditions or market sentiment inevitably change.
Broker dealers used to maintain large inventories of HQLA as the dominant intermediaries in fixed income and equities markets. However, recent major regulatory changes brought about principally by Basel III and Dodd-Frank have led these firms to cut back substantially on their trading books, transforming the market landscape, reducing liquidity and accessibility to HQLA. The impact of change on banks, and broker dealers in particular, such as tri-party repo reform has brought stability but at the expense of liquidity, and with increased costs for this traditional source of funding.
As the requirement to reduce the size of sell-side balance sheets has continued, opportunities have opened up to help bridge the mismatch between supply and demand of HQLA, as part of an integrated collateral management programme generating both liquidity in the marketplace, and incremental returns for asset owners.
The concerns raised by sovereigns surveyed for this report – counterparty risk, legal obstacles, regulatory barriers and limited secondary markets – will need to be addressed if they are to play an active role in easing these liquidity pressures. Their own internal governance rules may also need to evolve in order to realize the benefits of this new role at the center of global financial markets.
Brian Ruane, CEO of Broker-Dealer Services & Head of Banks, Broker-Dealer and Investment Advisors Market and Alternative Asset Manager Segments, BNY Mellon
‘Liquidity is the price you pay for stability’ – the impact of regulations on capital and liquidity have dominated the financial landscape since the financial crisis, creating an ongoing shift towards a more collateralized world.
Efforts to increase transparency and collateral mobility, as well as the safety and soundness of the global financial markets, have materially increased the demand for high quality liquid assets (HQLA)— outpacing the demand for all other asset types. Collective action taken since the crisis, including the regulatory imperative to clear and collateralize over-the-counter swaps, the requirement to hold such assets to meet liquidity standards, and the increased amount of cash in the system due to economic stimulus, are creating ongoing concerns around the continued availability of liquid collateral. In short, HQLA is now viewed as the financial system’s most important commodity.
Regulations stemming from Basel III, most notably the supplementary leverage ratio, the liquidity coverage ratio and the net stable funding ratio, are leading banks and broker dealers to continue to reduce their balance sheets, streamline operations, optimize posted collateral and allocate capital more selectively to individual business lines.
The requirement that banks hold higher and more liquid capital and rely less on short-term debt has raised funding costs. Regulation has also increased the cost of funding inventories through repo markets, thus market making has become less attractive to banks.
U.S. tri-party repo infrastructure reform has global implications due to the global importance of the U.S. Treasury market and Treasury holdings as risk-free assets. BNY Mellon explored this in greater depth in our recent paper ‘The Future of Wholesale Funding Markets.’
At this juncture, the narrative around wholesale funding and collateral management will likely move from the pure macro impact of regulatory reform to more specific implementation strategies and the emergence of market and regulatory reform.
A complex array of priorities facing the industry highlights the importance of having a comprehensive roadmap to help guide a firm’s collateral strategy and the new opportunity for sovereign institutions as natural long term holders of HQLA. An increased focus on a global view of collateral management and the introduction of cleared repo products in the U.S. are expected to remain at the forefront of change, helping markets and clients alleviate pressures from risk, regulation, and operational burdens. The ability to mobilize collateral across legal entities and countries is becoming increasingly important to the global financial system. Collateral mobility will improve the liquidity in the funding markets by making larger quantities of high quality assets more readily available to be moved across global liquidity pools.
BNY Mellon believes that our position as the U.S.’s largest tri-party repo agent and holder of collateral gives us a unique insight into the evolving market and provision of robust global collateral management solutions. We are delighted to partner with OMFIF on this important research paper on liquidity and look forward to engaging with you on the issues it raises in the period ahead.
For more insights from the key contributors, please watch our accompanying video or download the report.
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Executive Vice President and CEO, EMEA Investment Services, BNY Mellon
CEO of Broker-Dealer Services & Head of Banks, Broker-Dealer and Investment Advisors Market and Alternative Asset Manager Segments