With risk markets reaching all-time highs and frothy with liquidity in early 2021, the seizing-up of financial markets amid pandemic fears in March 2020 may seem to some like a distant memory. But for those stakeholders concerned with financial stability, such as the U.S. Financial Stability Oversight Council, the events that led to the bouts of significant liquidity challenges last March – and importantly, the lessons from that experience – remain in sharp focus.
As large, active market participants who are stewards of the assets of both individuals and institutions, we at PIMCO care deeply about the stability and healthy functioning of the financial markets. Like other market participants, we found the market turmoil in March 2020 challenging and believe that as U.S. policymakers continue their postmortem analysis, there are several key takeaways about what worked and what could be done differently.
What happened in fixed income markets in March 2020?
A perfect storm of dynamics led to the seizing-up of fixed income markets in March 2020. At the center was the unprecedented plunge in economic activity and the ensuing uncertainty about both the virus and the economic outlook, which caused a decline in valuations as concerns about solvency (real and perceived) took hold. Many levered market participants, such as hedge funds and real estate investment trusts (REITs), were forced to sell securities to meet margin calls, often selling whatever they could, which put further downward pressure on prices and impeded liquidity (for details, see this April 2020 bulletin from the BIS (Bank for International Settlements)). Asset price declines also led to rebalancing among some non-levered asset owners, which required asset managers to transact regardless of the market environment, thereby placing more downward pressure on valuations.
These factors all culminated in nearly indiscriminate liquidity challenges across sectors, starting out in U.S. Treasuries – typically the most liquid market – and then quickly expanding to other sectors.
Which specific factors exacerbated the liquidity challenges?
While the virus-induced economic halt was the genesis of the March 2020 market sell-off, there were several other factors that exacerbated market liquidity challenges:
- Most traders started working from home effectively overnight, which made trading that would have already been operationally complex even more difficult, likely leading to greater aversion to risk-taking by banks.
- Dodd-Frank banking regulation, which had made the banks more resilient following the global financial crisis, also made it harder for banks to make markets and engage in repo trading as balance sheet capacity declined amid higher volatility.
- The market structure of bond trading, which is still largely intermediated through banks, meant that when banks (dealers) were unable to or reluctant to make markets amid the March turmoil, it became exceedingly difficult for asset managers and asset owners to transact even in the most liquid markets.
- A perception circulated that prime money market funds – specifically those that take credit risk – could be liquidated in short order and without any material discount. An unintended side effect of the 2016 money market fund reforms, this perception created a pernicious cycle as investors demanded more liquidity the more positioning deteriorated in these prime funds.
Before we delve into what could be improved, it is important to note that despite a perfect storm of challenges, the financial system – broadly – held up. In the mutual fund space, for instance, 100% of U.S. bond funds were able to meet redemptions despite challenging market conditions (according to ICI).
From the fixed income perspective, a few key dynamics stood out:
- Central bank intervention: Comprehensive, timely, and coordinated interventions by global central banks were instrumental in restoring market functioning and confidence. From the direct bond-buying to the alphabet soup of emergency facilities, the U.S. Federal Reserve (Fed), in tandem with the Treasury Department, acted decisively to provide crucial liquidity and support the functioning of financial markets. More recently, we have welcomed the scaling-back of the use of these emergency Fed facilities now that liquidity and risk appetites have largely been restored, as we believe such facilities are best used in a temporary and emergency capacity.
- Mutual fund regulations, including recent liquidity reforms: Effective liquidity and risk management were also instrumental in ensuring that mutual funds were able to manage flows in March 2020. While flows were heavy, they were manageable and importantly did not have knock-on, systemic effects, which was the result, in part, of the stringent leverage, concentration, and counterparty requirements that 40 Act mutual funds must meet. Moreover, recent mutual fund reforms, such as the SEC’s liquidity rule (which requires all mutual funds to embed liquidity risk management programs and minimum liquidity investment thresholds), were also shown to be helpful industrywide. Lastly, we would note that we do not believe that either redemption gates or redemption fees, which have been contemplated previously, would have helped to mitigate the market liquidity issues during the March 2020 turmoil, and indeed, may have simply exacerbated them.
- Derivatives: Unlevered derivatives transactions are an important tool for active managers to manage liquidity, and we believe their usefulness was evident yet again in March 2020 when unlevered derivatives were demonstrably superior in supporting effective and efficient risk transfer. Indeed, in some cases, at the heights of the market turmoil, a derivative with similar characteristics to an underlying cash bond was multiple times more liquid than that cash bond. The decades-long move to central clearing in certain parts of the derivatives market, spurred by reforms under the Dodd-Frank Act, also helped with price discovery during this time.
- Targeted regulatory relief: We also found the limited and targeted regulatory relief that the Federal Reserve provided to banks to increase balance sheet capacity – and thereby market liquidity – extremely helpful. The most important change was appropriately relaxing the supplementary leverage ratio1 (SLR) to allow for both reserves and Treasury bonds. In our view, this modification did not compromise banks’ stability, but it did provide needed liquidity to the market during a crucial time and arguably enhanced the effectiveness of the Federal Reserve’s liquidity facilities.
What could be improved?
While the broader financial system was fairly resilient, there are also some improvements that we believe could help to avoid the acute liquidity impairment we saw in March 2020:
- The broadening of the Federal Reserve counterparties that can access the Fed’s buying programs for U.S. Treasuries and agency mortgage-backed securities (MBS): The Federal Reserve system depends on a set of primary dealers – currently all banks – to make offers on Treasury bonds in the Fed’s purchase auctions, to provide liquidity to the system, and to broadly transmit its monetary policy. As of now, asset managers, such as PIMCO, cannot directly transact in these Fed operations, even though asset managers’ holdings of Treasuries are a major source of bonds offered to the Fed in these bond-buying programs. Instead, asset managers are forced to sell to the Fed through dealers, which charge for intermediating what is effectively a low-risk transaction. During periods of heightened market volatility, like we saw in March 2020, elevated transaction charges in the form of wide bid/ask spreads can be very costly for both asset managers (specifically their clients) and for the Fed, although they tend to generate windfall profits for dealers. By allowing asset managers to directly access the Fed operations, we believe the Fed would benefit from more competitive auction pricing. It is also worth noting that Fed operations are major market liquidity events, and as a result, broader market liquidity tends to improve around them. Therefore, increasing competition within the Fed operations may also improve market functioning more generally, including reducing Treasury auction concessions during periods of stress.
- A modest recalibration of banking regulation: The benefits of the Dodd-Frank reforms on the banking system were clear in March 2020 – banks, with their generally robust balance sheets, high quality capital, and plentiful liquidity, appeared effectively unscathed during the market turmoil. At the same time, banks’ balance sheets, because of the accompanying regulatory requirements, were so constrained that the banks could not make markets even in the lowest-risk short-term assets. While the Federal Reserve ultimately stepped in to provide some regulatory relief to allow for more balance sheet capacity, it was only after significant volatility. As a result, we believe policymakers should evaluate some of the existing Dodd-Frank requirements with an eye toward achieving a better balance between market functioning and efforts toward banks’ stability and soundness. At a minimum, we would encourage the Federal Reserve to make permanent the temporary changes it imposed in April 2020 to the supplementary leverage ratio (SLR) – specifically to exclude U.S. Treasury securities and reserves from the SLR calculation – a change that is set to lapse at the end of the first quarter of 2021. We believe this change does not compromise the stability and soundness of the banking system, but it does provide banks with important flexibility, especially in a crisis.
- Increased transparency around repo margining: We believe the extreme volatility in March 2020, which was exacerbated by the forced selling of levered players, exposed the need for more transparency around margining in Treasury repos in particular. While the U.S. Office of Financial Research has been collecting repo data, it does not necessarily have access to high-frequency data or visibility into levered participants’ borrowing in portions of the repo market. This lack of transparency may have hampered policymakers from understanding the extent of issues facing the market in March and thereby hindered the timeliness of their response. More real-time transparency would provide regulators with better insights and clarity, particularly in a time of crisis, thereby providing policymakers a more informed position from which to act.
- Further development of all-to-all trading: The March 2020 market disruption highlighted some of the limitations of the existing fixed income market structure, namely that market participants still largely trade through banks (dealers) in order to transact in the bond market. This process becomes problematic in times of stress when banks pull back from making markets. One way to mitigate this dynamic is the further adoption of “all-to-all” trading platforms, which could allow for asset managers and asset owners to trade with dealers (as they do now) but also enable trading with each other. This type of trading could foster additional sources of liquidity, less reliance on a handful of banks, and lower costs, in our view. In time, it could also ease markets’ reliance on the Fed as the liquidity provider of last resort. Policymakers could help accelerate adoption of these platforms by functioning as a convening power to bring different stakeholders to the table in order to establish and agree on a path forward.
- Reassessment of liquidity requirements for regulated prime money market funds: In response to the 2008–2009 financial crisis, the U.S. implemented regulations that sought to make prime money market funds more resilient. One of these updated regulations required boards of prime money market funds to consider halting redemptions if their weekly liquid assets fell below 30% of the fund’s value. While the intentions of this regulation were well-meaning, the transparent daily reporting of liquidity unwittingly created an incentive for concerned investors to rush to redeem as soon as the reported fund liquidity began to near the 30% threshold. When combined with the limited ability of dealers to warehouse risk on their own balance sheets, including commercial paper commonly owned by these funds, this liquidity requirement effectively prompted front-end credit markets to freeze in March 2020. In our view, this experience highlighted the need for improved liquidity requirements for prime funds as well as the unintended downside of the daily reporting requirement for prime funds.
Conclusion: Market fragilities suggest targeted policy shifts
While we would contend that the financial markets broadly held up despite a perfect storm of factors, the market turmoil in March 2020 exposed fragilities in certain segments of the market and highlighted areas where a reevaluation of existing regulations or a consideration of new, tailored regulations may make sense. We also believe that the March rout underscored the importance of opening up sources of liquidity and expanding access to bond trading. By considering the possibility of reforming regulation to allow countercyclical risk-taking by market makers and of expanding the footprint of all-to-all trading platforms, policymakers could help reduce the necessary reliance on central banks in future crises.
With that said, with respect to future reforms, we would encourage policymakers to act in a targeted manner and not disregard the range of effective and supportive policies already in place or impose new regulations that could exacerbate liquidity issues in a future time of stress.
Sudi Mariappa and Jerome Schneider contributed insights and data to this paper.