ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Strange and Worrying International Market Liquidity

There seems to be a rise in illusory liquidity in international markets, which appears to be plentiful in quiet times, but vanishes at other times. “Flash crashes” are more frequent. Reforms that have made banks safer have contributed to this, leading to a withdrawal of short-term market participants, and causing long-term investors to act short term. There seems to be a trade-off between day-to-day liquidity and what I call “systemic liquidity.”

The economic recessions that follow banking crises are deeper and longer than other recessions. At the centre of most banking crises lie liquidity crises. The Great Recession that engulfed the United States (US) and Europe from 2007 was essentially a funding liquidity crisis. The majority of bank assets were performing in 2007. But a collapse of confidence in the veracity of the ratings of credit instruments owned by banks meant that they could not sell these assets for immediate liquidity without taking a big hit to their worth and bank solvency, and they could not put up these assets as collateral for cash without accepting large haircuts. Observing this, nervous bank customers began withdrawing their deposits, compounding the liquidity shortage. Banks stopped lending to each other. The authorities stepped in and the rest is history. Market liquidity matters.

Given the history, you can imagine that the authorities are particularly sensitive to claims now being made by market participants in London and New York that market liquidity in some of the traditionally most liquid financial markets is falling. Worse, market participants argue that this is a direct result of the international regulatory reforms since the crisis promoted by the Financial Stability Board (FSB) of G20 finance officials, where India is represented by the Reserve Bank of India (RBI), Securities and Exchange Board of India, and the Ministry of Finance.

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