The Bank of England has identified the reduction in liquidity in some markets as one of the the main risks facing the financial system in the UK and said it will look at the activity of investment funds and hedge funds over the next year.

In the latest Financial Stability Report, the Bank listed the main risks facing the UK financial system as the global environment; the reduction in market liquidity in some markets; the UK’s current account deficit; the housing market in the UK; consequences of misconduct in the financial system; and cyber attack.

To investigate concerns over market liquidity the Bank intends to undertake a regular deep analysis of a range of activities. The report said: “This will start over the next year with the investment activity of investment funds and hedge funds, the investment and non-traditional, non-insurance activities of insurance companies, and securities financing and derivatives transactions.”

The study highlighted some fixed income markets as becoming less liquid as average trade sizes and market depth have fallen and prices have become more volatile. “The pricing of a range of securities seems at present to presume that they could be sold in an environment of continuous market liquidity. Estimates of the compensation investors require to bear liquidity risk are similar to before the crisis,” added the Bank.

The Bank is worried that a repricing of risk would threaten financial stability if it were to cause dislocation of important financing markets for financial intermediaries and the real economy, which could affect the resilience of the core banking system.

The Financial Policy Committee at the Bank set out a programme of work to clarify the extent of any macroprudential risks associated with market liquidity in March this year and the final report is due to presented in September. The Bank said it is also working with the Financial Stability Board to assess these risks globally.

One reason for the reduction in liquidity is that dealers have become less willing to expand their inventories and to take directional positions, particularly in less liquid assets, due to new regulations.

“To date, transaction volumes have been unaffected; rather, inventories have been worked harder – the value of transactions per unit of inventory stock for corporate securities now stands at around 30 compared to six at the time of the crisis,” said the report. “But dealers’ willingness to expand their inventories to alleviate the price impact of a large sell-off has yet to be properly tested in the post-crisis period.”

The definition of liquidity in the fixed income market is also important under the proposed MiFID II regulations, covering financial markets in Europe, as certain pre-and post-trade requirements will come into force for only liquid instruments.

The European Securities and Markets Authority has suggested two possible measures for measuring bond liquidity under MiFID II. The proposed instrument by instrument approach (IBIA) measures bond liquidity on a case-by-case basis, and continually measures bonds as they trade in the markets. The alternative class of financial instruments approach plus (COFIA+) classifies bonds into groups, such as sovereign or corporate, and measures liquidity by the size of issuance.

The Investment Association, which represents UK investment managers, has analysed bond trading data and made a recommendation to European regulators. Daniel Godfrey, chief executive of The Investment Association said in a statement: “European regulators now have the data to justify adopting COFIA +.”

The association said the data showed that bonds can reasonably deemed to be liquid for issues larger than than €2bn for corporates and €5bn for sovereigns.

In order to help fixed income market participants find liquidity, technology company Algomi has built a network for matching bond buyers and sellers. Tim Binnington, head of marketing and communications at Algomi, said in an email to Markets Media that €1bn would be considered benchmark size for corporate bonds – but even these issues become illiquid after the first month.

“In my view, any measure of liquidity can be reasonably well-predicted by the bid/offer spread,” he added. “My experience with asset managers purchasing bonds was that liquidity risk was determined by the size of amount Issued, amount outstanding and bid/offer spread.”

Binningto noted that the iboxx bond benchmarks, used by many fund managers, have much lower issuance size requirements of €500m and £250m. “That means that measuring fund performance (relative to benchmark) will necessarily include the performance of a raft of these illiquid instruments i.e, fund managers cannot simply avoid ‘illiquids’,” he added.

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