Proteus was a Greek mythological sea-god who was so slippery he could change into any shape he chose. There is no more protean word in finance than liquidity. For some, the word denotes the excess of cash currently chasing meagre market returns, For others, the word has a Keynesian meaning: liquidity preference is investors’ desire for cash. Yet others dwell on the fact that liquid assets are those that can be sold quickly, and so deserve lower returns than illiquid ones.
For those in the markets, however, liquidity is the ability to trade an instrument in large volumes without shifting the price. It is seen as a good thing, of itself. This needs to come with a health warning, however. For what is promoted as being liquidity is often merely trading volume, and from an investor’s perspective this can be misleading, as two examples indicate.
The first example comes from secondary trading in European government bonds. This takes place almost exclusively on quote-driven electronic platforms, notably Euro MTS, which has become notorious as a result of Citigroup’s controversial bond trade last year which is now the subject of multiple regulatory probes.
While trading on Euro MTS and other platforms takes place between banks, arguably the most important players are the eurozone governments that issue the bonds. They tout the volume of secondary trading on the platforms as evidence for liquidity in their debt. They like to contrast this with the fact that “off-the-run” US government bonds suffer a premium because of their illiquidity—an anomaly that the hedge fund Long-Term Capital Management infamously tried to arbitrage. The supposed liquidity of European bond markets is hence held up as an example of the single currency’s success.
But some of this supposed liquidity may be sham. Eurozone governments rely heavily on volume statistics provided by Euro MTS and others in deciding where to allocate valuable syndication and advisory business. And that may be encouraging dealers to trade between themselves, without any client or risk-taking purpose, purely to inflate the numbers and win business. A senior bond trader at a large bank says he has spotted big trades going through with zero bid-offer spreads – and has spoken to the UK’s Financial Services Authority about it in the context of its Citigroup probe. The head of funding at another large financial institution says he also believes sham trades are taking place.
Euro MTS plays down the phenomenon. It says that it has systems in place for detecting artificial volumes between dealers, and immediately reports infractions to regulators—although it refused to spell out what those systems are detecting, saying it was bound by confidentiality. The FSA refused to comment.
While no-one is suggesting that eurozone government bonds are not liquid in comparison to other asset classes, until more is disclosed, investors should take enthusiastic claims of liquidity in eurozone government bonds with a pinch of salt.
The second example comes from the brave new world of credit derivatives, which has become the main vehicle for trading in corporate debt. Over the last couple of years, the big dealers in credit derivatives have joined forces to create indices of corporate debt called iTraxx in Europe and CDX in North America. With 125 names in iTraxx for example, the new indices are less cumbersome than the capitalisation-weighted indices (such as the Lehman Brothers aggregate) traditionally used by bond fund managers as a benchmark.
With the help of 3rd parties such as Dow Jones which manage the indices, the big dealers have started marketing products based on iTraxx and CDX to asset managers and pension funds. Typically, the investor is offered synthetic exposure to the index constituents via credit default swap contracts in return for a spread which outperforms government bonds.
The big advantage of the new indices being touted by the dealers is—wait for it—liquidity. Unlike the old cap-weighted bond indices, iTraxx and CDX are liquidity-weighted. In practice what that means is that twice a year, the big dealers provide default swap trading volumes to Dow Jones, which aggregates the data and composes the index using the 125 most-traded corporate names.
That’s got to be a good thing, say dealers, because a good index is one that can be easily traded. Wrong, respond the asset managers. They fear that the most heavily traded corporate names making up the index may be those whose bonds or loans are being sold fastest by the dealers. That would be bad enough. But there’s potentially an extra problem that comes from the fact that dealers often work for integrated commercial banks that also lend money to companies.
There are supposed to be Chinese walls between the lending departments, which often have inside information about problem customers, and the dealers. But bond investors are worried that this information may sometimes seep through the Chinese Walls. If so, an asset manager who signed up to passively own the iTraxx constituents might find himself, at the next turn of the credit cycle, owning precisely those corporate names that no bond fund manager would want to own.
These two examples serve as a warning to investors. Liquidity is such a protean, slippery concept that its use as an investment guide is questionable and easily abused.
This article originally appeared on www.breakingviews.com.
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