Bank of England delves deeper into market illiquidity conundrum
By Huw Jones and David Milliken
LONDON (Reuters) - The Bank of England's risk watchdog will extend its focus beyond making banks more stable to look at the lack of liquidity in fixed-income markets, which are now braced for more volatility as bonds price in eventual interest rate rises.
The Bank's Financial Policy Committee (FPC) said in its twice-yearly report on Wednesday that some markets had become less liquid to cope with heavy sell-offs, but the reasons for this were "not yet well understood".
The BoE said it was conducting a review into markets that will report back in September.
Widening its focus to include markets takes the FPC into the territory of Britain's Financial Conduct Authority.
"While the resilience of the institutions at the core of the financial system has continued to strengthen, risks are shifting to the markets that connect them, and to the infrastructure that underpins them," BoE Governor Mark Carney told reporters.
Investors wrongly assumed they could easily sell bonds at any time, the FPC said.
Regulators were alarmed by episodes of extreme volatility in bond markets like last year's "taper tantrum" in U.S. Treasuries, and are unsure whether or how to react.
"Volatility is moving back towards historic averages. It feels a little more sharp as it's been suppressed for quite a period of time," Carney said.
He noted a doubling of activity by asset managers, who are having to find more liquidity, and the FPC's review has surveyed 135 asset managers in Britain.
The worry is that when interest rates begin rising, the repricing of bonds could lead to "persistent dislocations" in markets used for financing companies, he said.
"This is one reason why the FPC is interested in the activities of asset managers," Carney said.
Philip Shaw, an economist at Investec, said liquidity had been reduced for some time before being unearthed by recent market flows. "That's what a lot of our traders have been saying for a while."
REGULATORS CLASH
Central bankers and market watchdogs have clashed over what, if anything, should be done to alleviate reduced liquidity, such as curbing outflows from bond funds in extreme sell-offs.
Some central bankers have suggested they could step in to provide liquidity but market regulators say this would hinder markets from adjusting to new circumstances like higher rates.
Carney said any action must be "evidence-based" as liquidity finds a "new normal" level.
"If it's a period of adjustment, it may be better to just let that flow through, but if it's going to mean that markets are not functioning effectively ... we should do something about it," Carney said.
"We are open-minded about how it's going to evolve and therefore open-minded about what, if anything, should be done to correct it."
Market watchdogs say curbs on investors taking their money out of funds during extreme sell-offs are tried and tested, meaning no new intervention is needed.
Carney said it would be "somewhat surprising" if such liquidity management rules and strategies put in place by asset managers during pre-crisis years of higher "false" liquidity were still "ideally suited" to today's market.
(Editing by Catherine Evans)
