FX Liquidity Conditions Linked to Dealer Constraints: BIS Paper
Posted by Colin Lambert. Last updated: February 15, 2023
A new Working Paper published by the Bank for International Settlements (BIS) finds that dealer constraints in FX spot markets have significant adverse implications for market liquidity, with liquidity provision weakening by up to 80% when such constraints are in play.
The paper uses the FX spot market but observes that the findings are likely to be as relevant in other OTC markets – indeed, given the relatively low cost base of providing liquidity and risk warehousing in spot, one could argue that the impact is likely to be even greater in those markets where balance sheet usage is much higher.
The constraints cited by the paper include higher leverage ratios, value-at-risk measures and debt funding costs and represent, it says, “the shadow cost” of providing liquidity in markets. It finds that during such constrained regimes dealers’ supply of liquidity is insufficient to curb the deterioration in liquidity conditions. Unsurprisingly perhaps, it also finds that liquidity costs “may” deteriorate when markets are more volatile because the dealers may be more constrained.
The paper also finds that a rise in these constraints generates “widespread violations of no-arbitrage conditions”, although the latter is always likely to arise if and when LPs are showing an “axe” to reduce their risk exposures. It asks two key questions, do these conditions increase the cost of liquidity in markets, and do dealers reduce their market making activity when so constrained?
The answer to the first question is an unequivocable ‘yes’, with the study finding that not only do constrained conditions increase the cost of liquidity, they also mean dealers’ supply becomes less elastic. It notes that if the balance sheet capacity of dealers is depleted, “their ability to intermediate markets is reduced”, although again, this is likely to be more of an issue in markets other than spot FX, where the balance sheet impact is significantly lower (witness the rise of non-bank market makers with very limited balance sheets).
The paper also finds that constraints mean dealers are less inclined to hold large inventory for market making purposes, thus the quantity of liquidity provision also suffers.
Overall the paper highlights a phenomenon in FX markets since the GFC and subsequent response by the authorities – regulatory charges are having a bigger impact. It is notable that the paper finds dealers’ cost of liquidity provision increases disproportionately relative to dealer-provided volume in the market, but the sense is that the broader findings are likely to be more relevant in non-spot markets, hence it would be interesting to see a similar study conducted in those markets.
In 2019, another BIS study found that balance sheet and regulatory constraints around quarter and year-ends increased the cost of hedging in the FX swaps markets, although using data from a different market, this paper seems to confirm those findings.
The full paper can be accessed here.