Investors are reaching for a toolkit of exchange traded funds, mutual funds and credit derivatives to make up for a dearth of liquidity in parts of the financial system, according to market participants and research from Barclays.
Regulations intended to improve the stability of the financial system after the 2008 crisis have sucked liquidity from large swaths of the financial market, making it more difficult to trade assets without affecting their prices.
At the same time years of low interest rates have encouraged large investors to pour money into similar positions, further sapping their ability to dart in and out of investments, and forcing them to consider new ways of trading assets.
Many have turned to ETFs, mutual funds and certain derivatives to make up for a lack of liquidity. ETFs use a network of banks and trading firms to give investors cheap and instant exposure to a wide variety of assets.
The trend is particularly pronounced in the fixed income market, where new rules aimed at increasing bank capital and reducing the risk of a run in the “repo market”— Ground Zero for the financial crisis — are said to have most hurt ease of trading.
Barclays analysts led by Jeffrey Meli warn that regulators may have traded extra safety in the repo market and banking system for a new type of “ fire sale” risk in ETFs and bond funds as investors make increasing use of the alternative trading vehicles.
“Regulations aimed at bolstering stability at the core of the financial system, combined with a growing demand for liquidity, may eventually lead to increased instability and fire-sale risk in the periphery,” the analysts said in research published on Tuesday. They cited risks in the secondary market for illiquid assets such as corporate bonds and leveraged loans.
“ETFs are being used not only by end investors looking for instruments with daily liquidity, but also by mutual funds seeking to mitigate the differences between the liquidity their investors expect versus the (poor) liquidity available in the underlying bonds,” they said.
Taxable bond funds have received $1.2tn of inflows since 2009, according to the Barclays report, with $588bn flowing into investment-grade corporate funds alone. Meanwhile, credit ETFs have grown to account for about 2.5 per cent of the investment-grade corporate debt market and almost 3 per cent of the junk bond market.
Trading of derivatives indices tied to baskets of corporate credit is also said to be surging as investors use the derivatives as a proxy for the illiquid cash market. The Barclays analysts said big investors tended to liquidate their exposure to the CDX — an important credit index — to raise cash during outflow periods, and increase CDX exposure when they had inflows and needed to put the money to work.
Research by eBond Advisors, a New York-based company, claims that trading of “single-name” credit default swaps tied to individual companies has increased since the crisis.
The company is aiming to create a type of debt that would automatically embed new issue corporate bonds with CDS to improve liquidity in the asset class.
It argues that the post-crisis shift towards central clearing of derivatives has encouraged more investors to make use of derivatives tied to corporate credit, and that combining the two could improve liquidity in the wider corporate bond market.
“If we’re really trying to bring corporate borrowers all the potential investors seeking credit risk, then we should be looking to the CDS market for the significant additional liquidity it brings to the borrower’s benefit,” said William Bryan Jennings, chief executive of eBonds and former head of fixed income capital markets at Morgan Stanley.
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