Reacting to lower market liquidity

Newly half of institutional investors expects the lower market liquidity to be a continuing development. Using survey, State Street and the Alternative Investment Management Association have investigated the effects of this trend.

In response to the financial crisis in 2008, supervisory authorities tightened the regulation to stabilise and strengthen the financial markets, including the increase of equity requirements of banks and the reduction of their proprietary trading. However, because of stricter regulation, but also because of lower interest rates and weaker economic growth, banks have withdrawn from the markets and were no longer able to exercise their traditional role as market makers.

Now 30 percent of asset managers surveyed by State Street say their portfolio has been less liquid during the last three years. Nearly half (48%) also believe that this will remain as is in the long term. Thereby, the survey of 300 institutional investors, asset managers and hedge funds reveals new market trends and the adjustments made by the market participants.

Institutional investors and asset managers adjust their asset allocation as a response to the lower liquidity. On the one hand, a more liquid vehicle should be used to obtain a desired market exposure, for example, ETFs (53%) or liquid alternatives. Also, many want to hold more cash reserves to service liabilities and redemptions (44%). Finally, asset owners and managers plan to reallocate investments, although the strategies used can be quite different: Some asset managers are trying to invest money in asset classes that are becoming more liquid in the future and thereby hedge themselves against market turmoil. Others, on the other hand, increase the share of high-growth illiquid asset classes, such as real estate and private equity, to increase yields.

Besides, the roles of some market participants are changing. 49 percent expect non-banks to become more important as market makers. Hedge funds, in particular, want to fulfil this role: 43 percent of surveyed hedge fund managers claim to evaluate their role as market makers for certain asset classes.

Buyers and sellers can also be brought together efficiently using electronic trading platforms. They increase the transparency of prices and spreads, improve the flow of information as well as the visibility of alternatives. 6 out of 10 respondents thus believe that the OTC trade is further automated - just as many expect that this can help to prevent liquidity bottlenecks.