BlackRock Investment InstituteSeptember 2012

Got Liquidity?

[ 2 ] G o t L i q u i d i t y ?

Richard Prager Head of BlackRock Trading

and Liquidity Strategies

Ewen Cameron Watt Chief Investment Strategist,

BlackRock Investment Institute

BlackRock investment institute

The BlackRock investment institute leverages the firm’s

expertise across asset classes, client groups and regions.

The Institute’s goal is to produce information that makes

BlackRock’s portfolio managers better investors and helps

deliver positive investment results for clients.

Lee Kempler Executive Director

Ewen Cameron Watt Chief Investment Strategist

Jack Reerink Executive Editor

What is insideFirst Words and Summary 3

Collateral damage 4

the Liquidity Challenge 5

Phantom Liquidity 7Supurna Vedbrat Co-head of BlackRock Market Structure

and Electronic Trading team

drivers of the Liquidity Challenge

New financial services regulations are facts of post-crisis

life. They are meant to reduce the risk of a new credit crisis

and to boost transparency to politically acceptable levels.

Banks and dealers have already started to comply by

pulling back from trading and selling “risky” assets.

Higher Capital Standards: Basel III requires banks to

increase equity to 7% of their risk-bearing assets by 2019,

almost three times the current requirement. Global banks

must hold an additional 2.5%. Banks can beef up capital

by raising new equity (costly because of little investor

appetite) or reducing risk assets (bad for market liquidity).

Banks must hold enough “high-quality liquid assets” to

match expected cash outflows in a 30-day period.

Proprietary Trading Curbs: The Volcker Rule, part of the

Dodd-Frank Wall Street reforms, limits proprietary trading.

Regulators elsewhere are implementing similar measures.

Chris Vogel Head of BlackRock Fixed Income

Trading, Americas

The opinions expressed are as of September 2012, and may change as subsequent conditions vary.

Bans and Taxes: Short-selling bans hurt liquidity in the

underlying instruments, especially because they typically

come at a time of market distress – when liquidity is

already challenged. Financial transaction taxes can

damage liquidity and ultimately raise costs for investors.

Back to Basics: Some complex and poorly understood

structured products blew up during the financial crisis.

Many investors are now avoiding them, harming liquidity

in credit markets. Meanwhile, regulators are changing the

landscape by requiring central clearing of many over-the-

counter (OTC) derivatives.

Ratings Downgrades: Ratings agencies are downgrading

sovereign debt and banks. The first forces banks to further

beef up capital to account for sovereign debt holdings that

are now seen as too risky. The second hurts their ability to

function as counterparties to OTC and other transactions.

B L a C k R o C k i n v e S t m e n t i n S t i t u t e [ 3 ]

First Words and Summary

Powerful forces are reshaping trading in financial markets:

raised capital requirements, curbs on proprietary trading,

moves toward central clearing of swaps and the steady

drumbeat of ratings downgrades of sovereign debt and global

banks. These changing regulatory and political tides, partly

triggered by the financial industry’s self-inflicted wounds of

trading losses and excesses, increase the risks of reduced

market liquidity.

The likely end result? A more transparent but less vibrant

marketplace for many securities and higher costs for investors.

This means higher bid-ask spreads on individual securities,

price gaps in response to macroeconomic news headlines,

and – most importantly – less room to carry out sizeable trades

without significantly affecting the security’s price.

Fixed income markets are showing the contours of this new

liquidity world. Ostensibly, these markets are booming.

New issuance is setting highs as companies take advantage of

record low interest rates. Yield-hungry investors are bidding

up prices of corporate bonds and other spread products.

Things are a bit clunkier beneath the surface. Traders are

splitting orders into small chunks to get them done. Liquidity is

concentrated in large and new issues, and drops precipitously

for smaller and older bonds. Liquid bonds are increasingly

trading at a premium to others. And nobody really wants to

contemplate what liquidity will look like once the bull market

in credit runs out of steam or reverses.

For now, there is still ample liquidity and a drying out in the near

future appears highly unlikely. But things are changing

rapidly. Investors do well to adjust to the new world of trading

and keep in mind we have only seen its very beginnings:

} Forget a return to the credit-fuelled heydays of the early

2000s. Markets were awash in liquidity and leverage then,

with great market depth (the ability to carry out large

trades quickly with minimal market impact) and the tightest

bid-ask spreads on record. This was likely an anomaly.

} a “back to the future” scenario is likely. This means

markets with pockets of liquidity, price differentials based

on how easy it is to buy or sell a security, and a renewed

appreciation for skills to carry out financial transactions

across a plethora of trading venues. This exposes portfolios

to risks, but also offers opportunities to smart investors.

} Watch market impact. Poor liquidity sometimes will mean

investors can allocate fewer funds to their best investment

ideas than they would like. A disciplined investor typically

evaluates if market depth is great enough to initiate a trade

– and, more importantly, can facilitate an exit. Compare it

to a lobster pot: Easy to get into, but tough to crawl out of.

} Perfect hedges are a mirage. The financial crisis showed

that liquidity is king and diversification often doesn’t work

in times of market stress. As a result, many hedges are

going to take the shape of blunt (liquid) instruments traded

on exchanges, rather than customised products that look

great on paper. For example, call options on long-dated US

Treasuries currently are a hedge against broad risk-off

market moves.

} Liquidity can be used in relative value investing. This is a

key strategy in stagnant markets with bouts of risk-on/risk-

off trading as detailed in “Standing Still… but Still

Standing” in July 2012. Investors can take advantage of

situations where a security’s liquidity premium or discount

runs counter to their assessment of the underlying value.

Those with long time horizons can exploit illiquidity by

picking up hard-to-trade, discounted assets.

} Better price transparency does not necessarily mean

better liquidity. In fact, the opposite may happen. Dealers

do not like to advertise their holdings for fear of getting

stuck with them – especially at a time when it is becoming

costlier to hold risk assets on their balance sheets.

So What do i do With my money?tm

Pre-Trade Homework: Evaluate an investment’s likely

market impact. At what price can you enter and exit the

trade? Some of your best investment ideas may have to

take a back seat.

Blunt Tools: Use liquid, exchange-traded hedges to

protect your portfolio. They may be imperfect – but at

least they are tradeable.

Liquidity Opportunities: Investors with longer time

horizons can try to take advantage of price differences

between liquid and tough-to-trade securities.

[ 4 ] G o t L i q u i d i t y ?

Repo Regression european Repo market trends, 2001–2012

MA

RK

ET S

IZE

(€ T

RIL

LIO

NS)

Market Size ■Euro Share

EUR

O R

EPO SH

AR

E (%)

0

1

2

3

4

5

6

7

40

45

50

55

60

65

70

75

2001 2007 20112003 2005 2009

Source: International Capital Market Association’s European repo market survey. Note: Data based on biannual surveys. Data to the second quarter of 2012.

Collateral Damage

The world looks awash in liquidity. Central banks have pushed

interest rates to record lows and have gone on asset buying

sprees to resuscitate economic growth. Purchases of

government paper and other securities by the central banks

of the US, eurozone, China, Japan, Britain and Switzerland

have added almost $9 trillion in monetary stimulus since 2007,

according to Deutsche Bank research.

This geyser of monetary liquidity has not resulted in as much

credit creation as one might expect. In fact, money multipliers

in the developed world have steadily declined over the past

decade, keeping a lid on inflation in most developed countries.

Why? Credit ultimately is dependent on collateral – and

investors have become much pickier about collateral since the

financial crisis. They are highly selective and are hoarding safe-

haven assets such as US, Japanese, German and UK

government bonds.

New regulations such as centralised clearing of OTC

derivatives are driving up demand for high-quality assets

even more – and encourage more hoarding of this elite (and

by many measures overpriced) group of government bonds.

The near-death of structured products (market-linked

investments that use OTC derivatives) shows the mirror image

of this trend: avoidance of assets seen as too risky. The

business of packaging and selling structured products

underpinned much of the trading in fixed income instruments

during the Great Bubble of the early 2000s. (It also generated

huge investment banking and trading profits – which were

wiped out when the market imploded.) This once thriving

market is now a drag on liquidity.

Demand for structured products has dried up as investors prefer

“back-to-basics” strategies, and are suspicious of financial

engineering and fearful of risk. Financial intermediaries are

unable or unwilling to create and support new structured

products due to tighter capital rules and a general de-risking.

As a result, issuance of collateralised debt obligations (CDOs)

has imploded. See the chart below, left. This in turn has

dampened activity in other credit markets – even though

supply, demand and outstanding value of corporate bonds

and emerging market debt are at record highs.

Another example is the repo market, where banks access

funding from money market and pension funds in repurchase

agreements. This market shows the effects of risk aversion –

and illustrates how monetary policy is changing trading

and liquidity.

The repo market has made a comeback from the crisis days,

when worries about counterparty risks and the safety of

underlying collateral slashed volumes. But new stresses are

showing up. The size of the European repo market, for

example, contracted 10% to a two-year low of €5.6 trillion in

the first half. At the same time, the number of euro-

denominated transactions hovered around a record low of

57%. See the chart above.

The declines show both decreasing risk appetite (mistrust of

counterparties) and the competing effect of monetary policy.

Two long-term refinancing operations (LTROs) by the European

Central Bank have given European banks access to easy and

cheap cash, reducing their need to tap the repo market.

CDO

ISSU

AN

CE ($

BIL

LIO

NS)

Issuance Outstanding

OU

TSTAN

DIN

G CD

OS ($ B

ILLION

S) 0

100

100

300

400

500

0

300

600

900

1,200

1,500

20022000 2004 2006 2008 20122010

A Great Credit Machine Grinds to a Haltoutstanding Cdos and issuance, 2000–2012

Source: US Securities Industry and Financial Markets Association. Note: Data through the second quarter of 2012.

B L a C k R o C k i n v e S t m e n t i n S t i t u t e [ 5 ]

The Liquidity Challenge

Investors usually hail inventory declines as good news. Falling

inventories point to a future increase in activity: Either

demand is strong or businesses need to restock – or both.

Not so in the world of trading. A decline in inventory typically

equals a decline in liquidity. If you have fewer items on your shelf,

chances are you sell less (unless you offer deep discounts).

This is what has happened in the corporate bond market.

Risk aversion and preparation for stricter capital rules have

caused dealers to empty their inventories. Inventories of US

corporate bonds now total $59 billion, down 79% from a high

of $286 billion in late 2007. See the chart on the right.

Over the same period, the US investment grade bond market

grew by about half to more than $3 trillion, as issuers took

advantage of low rates and investors hunted for yield. The US

high yield market also grew, and now stands at well over $1

trillion. The mismatch between low trading inventories and high

demand and issuance is one factor that is restraining liquidity.

Dealers have swapped their corporate bond holdings for

(mostly short-dated) US Treasuries, due to the Federal Reserve’s

selling bills to buy long-dated Treasuries in “Operation Twist.”

US High Yield Emerging Market Debt European High Yield

0

50

100

150

200

250

2012201120102009200820072006

BE

ST-

TO-C

OVE

R L

EVE

L ($

CE

NTS

)

Rising Trading Cost Tide Best-to-Cover Levels of Fixed income markets, 2006–2012

Source: MarketAxess. Notes: The best-to-cover level is the difference between the executed trade price and the second-best dealer bid/offer. Data in US cents of bond price levels. European high yield data from 7 April 2008; other data from 3 January 2006. All data to 13 August 2012.

The Great De-RiskinguS dealer inventories, 2001–2012

DE

ALE

R P

OS

ITIO

NS

($ B

ILLI

ON

S)

20032001 2005 2007 2009 2011

-200

-100

0

100

200

300

Corporate BondsGovernment-Sponsored Enterprise DebtTreasuries

Mortgage-Backed Securities

Sources: MarketAxess and Federal Reserve Bank of New York. Note: Data to 11 July 2012.

Dealer positions in US mortgage-backed securities (MBS)

have gradually increased and now outnumber corporate bond

inventories, resulting in a vibrant agency MBS marketplace.

This market is supported by three sets of bidders: the Fed,

banks adding “quality assets” to adhere to the new Basel III

capital rules and real estate investment trusts, as detailed in

“in the Home Stretch? the uS Housing market Recovery”

in June 2012.

By contrast, falling dealer inventories of corporate bonds

are starting to challenge liquidity in those markets. Liquidity

constraints may not yet be visible or felt – but they are more

likely to get worse than better.

Things look good on the surface. Best-to-cover levels – which

measure the gap between the trade price and the next-best

offer – are way down from crisis levels. They rose during the

European debt crisis in late 2011, but are now only slightly

elevated from pre-crisis levels. See the chart on the left.

[ 6 ] G o t L i q u i d i t y ?B

ID-A

SK S

PREA

D (B

ASI

S PO

INTS

)

0

10

20

30

40

50

20032001 2005 2007 2009 2011

A New Bid-Ask Normal?Bid-ask Spreads on uS investment Grade Bonds, 2001–2012

Source: MarketAxess. Notes: Bid-ask spreads are daily estimates in basis points. The dark blue line represents a smoothed-out average. Data to 25 July 2012.

Bid-ask spreads on US investment grade bonds show a

slightly constrained liquidity picture. Spreads are far off their

2008–2009 highs, but elevated from last year and pre-crisis

levels. See the chart above. US high yield bid-ask spreads

have followed a similar path and now average $0.31, albeit

with much wider dispersion, according to trading platform

MarketAxess.

More importantly, markets have become shallower. This has

led to increased liquidity concentration in new issues, and

liquidity dropping off for older issues or run-off securities.

PER

CEN

TAG

E O

F VO

LUM

E

0

10

20

30

40

50%

Odd LotsRound Lots Block Trades Micro Trades

201220112010

Work That Order! trade Sizes of uS investment Grade Bonds, 2010–2012

Sources: MarketAxess and TRACE. Notes: Micro < $100,000; Odd = $100,000–$1 million; Round = $1–5 million; Block > $5 million. Data to June 2012.

For example, the top 2% of investment grade bonds by volume

rose to almost a third of overall trading in the first quarter,

according to MarketAxess. And the top quintile of bonds by

volume accounted for 93% of total turnover.

The liquidity is bunched up in large new issues. Only issues of

more than $1 billion and those less than a year old recorded

volume growth in 2011, according to MarketAxess. Liquidity of

older and smaller bonds dropped across the board.

The result? Many traders are now splitting up large orders in

US investment grade bonds to find buyers and sellers. The

average trade size was $381,000 in June, down 17% from a

year earlier. Trades of more than $5 million now make up 36%

of the overall volume, down from 45% a year ago. See the left

chart below.

Poor liquidity is depressing overall trading – even as yield-

hungry investors bid up prices and companies take advantage

of historic low financing rates by issuing more debt. Trading

volumes hit a high of nearly $3 trillion in 2009 and then

levelled off. This year volumes are on track to slightly exceed

their 2009 highs – but remain subdued as a percentage of the

total value of outstanding debt. See the right chart below.

As a result, highly liquid bonds now carry a premium of

around 16 basis points over less liquid ones, according to J.P.

Morgan research. This compares with an average premium of

about 6 basis points in the past seven years. See the chart on

the following page. By contrast, the MBS liquidity premium

has remained stable at 6 basis points (as measured by the

spread between Fannie Mae and Freddie Mac securities).

MA

RK

ET V

ALU

E ($

TR

ILLI

ON

S)

TRACE Investment Grade Trading Volume ■Market Value Trading Volume as % of Market Value

2012E201020082006

0

30

60

90

120

150%

1

1.5

2

2.5

3

3.5 PERCEN

TAGE O

F MA

RK

ET VALU

E

Sources: BlackRock, Barclays and TRACE. Notes: 2012 estimates are annualised first-half data. 2012 market value as of 29 June 2012.

When Liquidity Dries Uptrading volumes of uS investment Grade Bonds, 2005–2012

B L a C k R o C k i n v e S t m e n t i n S t i t u t e [ 7 ]

The Liquidity PremiumPremium of Liquid uS investment Grade Bonds, 2005–2012

LIQ

UID

ITY

PREM

IUM

(BA

SIS

POIN

TS)

-10

0

10

20

30

40

20122011201020092008200720062005

Liquid Bonds Rich

Liquid Bonds Cheap

Average Liquidity Premium = 6 bps

Sources: J.P. Morgan and TRACE. Notes: The liquidity premium is the spread between US investment grade bonds of the same issuer with similar maturity and daily volume of $3 million or more (liquid) and $1 million or less (less liquid). Spreads are monthly moving averages. Data to 26 July 2012.

Phantom Liquidity

Things look hunky-dory in equities, with bid-ask spreads

ever narrowing. The average spread on S&P 500 stocks now

is slightly more than a penny, according to Morgan Stanley.

Thank decimalisation, automation, the advent of high

frequency trading and a host of new trading venues.

In reality, these narrow spreads amount to nothing more than

phantom liquidity. Sure, the spread is a penny for 100 shares.

But what happens when you want to transact a million

shares? For most stocks, there’s no market. Consider:

} Block trades (trades of 10,000 shares or more) in S&P 500

companies make up less than 7% of total volume, down

from nearly 50% in the early 1990s. See left chart below.

} The average trade size of NYSE-listed stocks is down 75%

from the early 2000s. See right chart below.

transparency at a Price

Many new rules call for more price transparency,

including for OTC derivatives and US municipal bonds.

The hope is to create a level playing field and boost

liquidity by attracting new market participants.

The opposite effect, however, is a real possibility: Some

existing participants may withdraw for fear of tipping

their hand if their trading books are broadcast.

This is not to say price transparency is bad – far from

it. It is merely to flag unintended consequences. These

outcomes may be temporary as markets adjust, they

may be permanent or they may not happen at all.

Whichever the case, it pays to be prepared.

Phantom LiquidityBlock trades, turnover and trade Sizes of uS Stocks

Sources: Morgan Stanley and New York Stock Exchange. Notes: S&P 500 block trades are calculated by dividing each constituent’s dollar volume by the dollar volume of trades that exceed 10,000 shares. Daily data to 26 July 2012. Turnover is each SPX constituents’ daily volume as a percentage of its outstanding shares. Data to July 2012. Data for trade sizes of NYSE-listed stocks is through June 2012. All data are consolidated trading.

PER

CEN

TAG

E O

F D

AIL

Y VO

LUM

E

S&P 500 Block Trades

0

10

20

30

40

50%

200920072005200320011999199719951993 2011

0

250

500

750

1,000

0

0.5

1

1.5

2%

201220112010200920082007200620052004

NU

MB

ER O

F SH

AR

ES

Average S&P 500 Turnover Average NYSE-Listed Stock Trade Sizes

AVERAG

E TUR

NO

VER

High frequency traders would argue they play a crucial role in

providing liquidity. Critics contend they provide real liquidity

only in stocks that are already liquid.

Foreign exchange shows few signs of liquidity constraints, as

it is a flow business that does not carry a capital charge. Bid-

ask spreads on spot foreign exchange markets spiked during

the financial crisis but have since come down – although

they remain above pre-crisis levels in less-traded pairs such

as the New Zealand dollar and Norwegian krone. See the

chart below.

BID

-ASK

SPR

EAD

(BA

SIS

POIN

TS)

Australian Dollar-USD Euro-Norwegian Krone

Euro-USDNew Zealand Dollar-USD

0102030405060708090

201220112010200920082007

Awash in LiquidityBid-ask Spreads in Spot FX markets

Source: BlackRock. Notes: Based on quarterly BlackRock survey of 15 to 19 foreign exchange dealers. Bid-ask spreads in basis points are based on the average spread on a $100 million transaction dealers commit to 90% of the time. Data to June 2012.

How We tackle the Liquidity ChallengeBlackRock is pioneering new ways of doing business to ensure clients have access to a full range of investments:

Capital markets: A new desk that works with investment banks to source fixed income directly from issuers. This “originate to manage” model is meant to meet client needs for new corporate bond issues, allow customisation and deliver intelligence on market trends.

Crossing and matching: New trading platforms for equities and fixed income. Internal crossing networks enable buying and selling of securities between BlackRock portfolios and client accounts. A trading network for institutional clients allows access to a broad set of market participants.

etrading: New systems to tap into the liquidity of electronic trading venues. Already far advanced in equities, electronic trading is just starting to transform fixed income and foreign exchange markets.

adding Brokers: An emerging brokers programme targets enterprises owned by women and minorities as well as firms with regulatory capital of less than $2 million.

otC Central Clearing: A central clearing entity such as the Chicago Mercantile Exchange could become the counterparty in selected OTC transactions and reduce risk.

This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 2012 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents.

This paper may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader.

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