The Telegraph By Rebecca Burn-Callander
11:16PM GMT 15 Nov 2015
Tory MP Andrew Tyrie has asked for a detailed explanation on how Mark Carney plans to avoid ‘a vicious circle of declining liquidity’
In an open letter, Andrew Tyrie, who is also chairman of the Treasury committee, sets out several risks that are currently undermining the bond market – and gilts “in particular”.
These include the onerous regulation of the banking sector, which Mr Tyrie claims has reduced banks’ capacity as “market-makers” to “absorb fluctuations in supply and demand”.
Mr Tyrie asked Mr Carney to provide an explanation of how the Bank intends to avoid “a vicious circle of declining liquidity and financial distress among bond traders
He warned that investors who “do not trade actively” – like the Bank of England itself, which holds £391bn in gilts (24pc of the total) – are also constraining liquidity.
Attempts to unwind quantitative easing will increase the pressure on the bond market, he said, asking for clarity on how this process would be managed.
Read the letter in full below:
I am writing to you for the FPC’s view of a problem—the risk of declining liquidity in the bond market, and the gilt-edged market in particular—that has been brought to my attention.
There are some reasons for concern that market liquidity may become stretched in the future – in contrast with the ample liquidity conditions which have prevailed since the mid-1980s – and that financial stability and the infrastructure of the gilt market might be threatened:
• the ability of banks to act as market-makers is now constrained by new restrictions on their proprietary trading, and by higher risk weights applied to their trading positions.
This will have affected market liquidity by reducing the capacity of the market makers to absorb fluctuations in supply and demand;
• a substantial proportion of gilts is now held by investors who do not trade actively as liquidity providers, or who are constrained to hold gilts, so that their trading activity is confined to switching between gilts.
The Bank of England holds £391 billion, at end-June 2015, or 24 per cent of total gilts outstanding, which it bought in its quantitative easing programme.
It has undertaken to maintain this holding until further notice. The Bank of England does not trade its holdings.
The commercial banks and building societies are required to hold gilts to satisfy liquidity regulations and they currently hold £143 billion (9 per cent of the total). They can switch between gilts but must in practice maintain their total holding.
Pension and insurance funds hold £471 billion (29 per cent of the total); many of them, too, are constrained to stay in gilts. These developments will have affected market liquidity because they have reduced the population of active traders on whom market-makers can readily unload positions that they have acquired in their own trading;
• as the economy continues to grow, it is likely that bond yields will rise and bond prices will fall. Liquidity is likely to decline in a falling market.
Market makers will be reluctant to bid until they have some confidence that the bottom has been reached. As a consequence, there may be large and sudden jumps in prices and yields.
A ‘vicious circle’ of declining liquidity and financial distress among bond traders could be the consequence, affecting end investors and other gilt market participants, too.
Liquidity is important to the gilt market, and it will continue to be important, not only to investors but also to the government, which will need to finance the budget deficit, until it has been eliminated, and to refinance maturing gilts.
The Bank will also need to unwind quantitative easing at some stage. This is an issue for both the MPC and the FPC, as well as the DMO, because the way in which it is done will have implications for gilt market liquidity and financial stability.
I would be grateful for a detailed response, particularly about the risks to market liquidity and also – on which the Bank, the FPC, and particularly minutes of its meetings, have already provided some helpful guidance – about the relationship between the problems and the unwinding of quantitative easing.
I would also be grateful for a detailed explanation of arrangements for co-ordination of the Bank’s work on this with the DMO and the Treasury, as well as between the three policy making committees of the Bank, given the different statutory objectives and overlapping memberships of each. Among other things, it is important that respective responsibility for liquidity risk has been clearly identified.
RT HON ANDREW TYRIE MP
CHAIRMAN OF THE TREASURY COMMITTEE