31 May 2023

ECB Financial Stability Report: Gauging the interplay between market liquidity and funding liquidity

The ability of market participants to access funding and conduct transactions in an efficient way is a prerequisite for financial stability, providing shock-absorption capacity and, in turn, limiting the scope for shock amplification.

 Market liquidity and funding liquidity are inherently connected. When market liquidity evaporates, financial market pricing becomes less reliable and tends to overreact, leading to increased market volatility and higher funding costs. Funding liquidity enables market participants to take exposures onto their balance sheets, thus absorbing fluctuations in demand and supply in the name of efficient market functioning. Under extreme conditions, markets can stop functioning altogether. While liquidity has many dimensions, from a systemic perspective the interplay between market liquidity and funding liquidity^[1] is key, as these two dimensions can reinforce each other in ways that generate liquidity spirals. Cyclical factors such as the business cycle, systemic leverage, as well as monetary and fiscal policy affect the probability of liquidity stress arising. In the light of the current challenges of high financial market volatility, increased risk of recession, bouts of heightened risk aversion and monetary policy normalisation, this special feature constructs composite indicators for market liquidity and funding liquidity. It also attempts to identify what can cause poor market liquidity and funding liquidity conditions and to show how the two dimensions interact in the euro area.

1 Introduction

Concerns have recently been increasing over the resilience of liquidity. For much of the last decade, volatility in bond markets has been low (Chart A.1, panel a) and holdings of high-quality liquid assets (HQLAs) in the banking sector have been large (Chart A.1, panel b). Recently, though, these tailwinds have started to change direction. Despite a regime of continuing high excess reserves, liquidity conditions have become more fragile and, at times, unreliable. Moreover, a constellation of a subdued free float of high-quality debt securities and globally high inflation, which has introduced uncertainty as to the future path of monetary policy, has greatly increased volatility in bond markets.

Financial system liquidity has a market component and a funding component, both of which have structural and cyclical drivers. In theory, market liquidity (the ability to rapidly execute sizeable securities transactions at a low cost and with a limited price impact) can be distinguished from funding liquidity (the ease with which financial intermediaries can borrow). In practice, these two types of liquidity constitute financial system liquidity and can interact and – on occasion – reinforce one another in generating liquidity spirals. These components can be influenced by structural trends such as market-making practices, issue size, trade transparency and investor landscape.^[2] The dimensions of liquidity can also be strongly influenced by cyclical determinants which underpin shifts in liquidity regimes. Such cyclical determinants^[3], including investor risk appetite, macroeconomic conditions and global monetary policy cycles, have started to turn. This has given rise to concerns over a shift towards a regime of less system liquidity and more fragile liquidity.

This special feature develops composite indicators of market liquidity and funding liquidity and assesses how they interact. It introduces concepts pertinent to both market and funding liquidity. It then presents a suite of indicators that sheds light on the evolution of both concepts for the euro area in recent years, investigating the main drivers behind them and examining how the two dimensions interact.

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