Liquidity in the swaps market came under pressure as the COVID-19 crisis spread globally in late February into early March, then rebounded after governments and central banks intervened. To understand the nature of the crisis and the consequences of the official sector interventions, Greenwich Associates, in conjunction with ISDA, interviewed 172 buy- and sell-side swaps market participants in the UK, European Union, North America, Japan, Asia, Lain America, Africa and emerging earkets.
The results, published today in a new report, “The Impact of Covid-19 and Government Intervention on Swaps Market Liquidity,” examine the factors contributing to market illiquidity and how that illiquidity impacted various parts of the swaps market in different parts of the world. The report also outlines the impact of government intervention and explores the potential for future changes to the market structure.
According to its author, Kevin McPartland, head of research for market structure and technology at Greenwich Associates, as many as 96% of UK-based swaps market participants interviewed noted a decline or a large decline in overall interest rate swap (IRS) liquidity before government intervention; as many as 60% noted an immediate improvement after. “Obviously,” McPartland says, “central bank intervention was hugely effective in calming markets, although the appropriateness and adequacy of the specific interventions put in place are still being debated.”
The markets quickly regained their footing after the interventions and began processing the impact of COVID-19 on the global economy, the report notes. Yet, even as they began to digest the effects of the pandemic on the real economy, the top financial issue affecting liquidity was seen as the banks’ reduced risk appetite. “When we asked about the impact of financial regulatory reforms put in place over the past 10 years,” McPartland says, “most acknowledged that the reforms had, in fact, improved the strength and resiliency of the banking system. Buy side respondents in particular, also noted that these reforms reduced the capacity of banks to provide liquidity.”
Key data points covered include the quality of liquidity across products during the crisis; financial events related to COVID-19 that disrupted liquidity; as well as responses to market uncertainty and volatility. The report also looks at major obstacles to plain vanilla swaps liquidity during the crisis; intervention’s effectiveness in restoring market liquidity; and whether government intervention was appropriate and adequate. Additionally, the report discusses the best types of government interventions for market liquidity and the effectiveness of the Fed Repo Facility in restoring liquidity.
“Those we interviewed appreciated that the banks are safer than before 2008,” says McPartland, “but market participants remained concerned that banks were restrained from stepping into the markets to restore calm as they might have 15 years ago. While few wish for those days of highly leveraged institutions taking risks on the back of customer deposits, finding a middle ground is worth considering.”
He adds, however, that strains on short-term funding markets did prove to be particularly acute with sudden demand for cash coming from, in essence, the whole of the real economy, as well as traditional derivative market participants. “Examining improvements shouldn’t be overlooked,” he noted.