Financial Stability Paper 34: The resilience of financial market liquidity

Financial markets have been affected by a number of structural changes over the past few years. Innovation has generated a broad trend towards fast, electronic trading. And necessary regulation implemented in response to the global financial crisis to ensure the safety and soundness of core intermediaries has discouraged them from market making as principal – though this may also reflect greater risk aversion on their part. These developments, alongside occasional bursts of volatility associated with short-term illiquidity, have led to concerns that market liquidity may have become more fragile. Although episodes of heightened volatility and short-term illiquidity are not necessarily in themselves threats to financial stability, they could become so if they were to persist, amplify or spill over. This paper draws out common lessons from such episodes. Overall, the ‘normal’ level of liquidity in markets that are less reliant on core intermediaries appears to have increased – but in some cases to the detriment of resilience. In contrast, the ‘normal’ level of liquidity in markets that are more reliant on core intermediaries appears to have fallen – but with a likely increase in the resilience of those markets via the resilience of the core intermediaries themselves. This is consistent with recent episodes of volatility and illiquidity having centred on fast, electronic markets, including exchange-traded venues.