COVID-19 pandemic liquidity crunch for derivatives had roots in 2008 reform measures, ISDA says

July 1, 2020.

A disruption in derivative market liquidity in March, showing a stark pullback in the risk appetite of banks as the pandemic set in, may have been exacerbated by reform measures implemented following the financial crisis in 2008, according to a new report from an industry group.

Banks had liquidity reserves to weather the coronavirus downturn in part because of reforms introduced in the wake of the last crisis, but those same reforms also choked derivative markets in dire need of a cash infusion, said the International Swaps and Derivatives Association, a derivative traders organization based in New York City. 

In research published Tuesday, ISDA teamed up with Greenwich Associates to survey the impact of the pandemic on derivatives market liquidity and investigate the causes and scope of disruption that occurred this spring.

The swaps market was tightly squeezed in late February and early March, as business shutdowns triggered a panic among investors who competed for safe assets. As revenue flow stopped or reduced to a trickle, many businesses could no longer be trusted to continue making loan payments, diminishing their credit quality and spurring a need for short-term cash. 

The unbounded credit crunch was particularly damaging to the credit default swaps market, which saw a major drop in high-yield index liquidity before central banks took action.

In this environment, banks became more risk-averse and wary of breaking capital requirements imposed by post-2008 financial regulations, according to the survey results. Swap buyers found it more challenging to execute trades, especially larger ones, and the market shifted toward small to mid-sized transactions. 

“Both the buy and sell side felt that credit-crisis-era financial reforms ultimately made the banking system safer and better able to weather this current storm,” ISDA found. “However, almost as many swaps market participants also felt that those reforms reduced the capacity of the banks to provide liquidity to the markets and to extend balance sheet to businesses.”

The Dodd-Frank Act in the U.S. and the Basel III reforms in the European Union require banks to hold enough “high quality liquid assets,” such as central bank notes, government debt and corporate debt, to withstand a 30-day stress test. 

Massive liquidity injections from the and other central banks were a salve for the swaps market, though roughly a quarter to a third are still experiencing tighter liquidity conditions than normal. The Fed offered up $1.5 trillion in short-term loans in March, and has recently begun buying corporate bonds

The Federal Reserve has also used regulations to promote liquidity, capping dividend payouts and prohibiting banks from stock buybacks through the third quarter of this year. , the U.S.’s fourth-largest bank, cut its dividend for the first time since the 2008 crisis. Banks can survive a continued economic downturn, according to a recent stress test by the Federal Reserve, though they could lose up to $700 billion in a worst-case scenario. 

The report concluded that, while the post-2008 reforms have greatly reduced systemic risk to the banking system, countervailing reforms would help avoid future liquidity issues.

“While few wish for the days of highly leveraged institutions taking risks collateralized by customer deposits,” the authors noted that “finding a middle ground is a worthwhile endeavor.”