Markit’s Gavan Nolan wrote this piece
Liquidity has been one of the most important but least understood topics during the turbulence of the last three years. From the genesis of the credit crunch in the summer of 2007, through the banking crises of 2008-09 and now the sovereign debt turmoil afflicting the markets, the concept of liquidity has never been far from the discussion. But it has been a somewhat nebulous concept thus far, with analysts and commentators reliant on anecdotal evidence and casual empiricism.
Markit’s Liquidity Metrics hope to change this. The service provides an independent set of liquidity metrics, including a simple and transparent liquidity score. The metrics include:
- Bid/ask spread data (observed/calculated)
- Number of dealers quoting (based on dealer runs)
- Number of quotes each day (based on dealer runs)
- Markit composite depth information from Markit’s end-of-day service
- A liquidity score per reference entity-tier
An examination of how these metrics can bring transparency to liquidity follows, with special reference to the peripheral eurozone countries: Greece, Ireland, Spain, Portugal and Italy.
Bid/ask
The bid/ask spread is perhaps the most important determinant of liquidity. Chart 1 shows the average bid/ask spread on the five-year CDS point for the peripheral eurozone sovereigns. On March 31, just before the sovereign debt crisis really took off, the bid/ask spreads were relatively tight. Greece, the country at the centre of the storm, had an average bid/ask of just 10bp (its CDS mid-spread was 343bp). The other peripheral’s were all well below 10bp.
However, if we look at the bid/ask spreads this week, we can see that they have widened dramatically. This is to be expected – the CDS spreads of all five countries have widened sharply. But the expansion of the bid/ask spreads outpaces the widening in CDS spreads. For example, Ireland’s CDS spreads were 221bp on May 20 compared to 146bp on March 31 – a widening of 151%. But the average bid/ask has increased to 22bp from 5bp over the same period – a move of 440%. Portugal’s equivalent figures are 232%/800%, and the other sovereigns (Greece 218%/379%, Spain 174%/425%, Italy 134%/267%) show a similar pattern, though to varying degrees.
It is also evident that there was a big jump in the bid/ask spreads on May 19. This was after the German regulator Bafin announced a ban on naked CDS referencing eurozone sovereigns. The move created some uncertainty in the market and appears to have led to a disruption in liquidity. Overall, the disproportionate widening in bid/ask spreads in recent weeks suggests that liquidity has fallen.
Number of quotes
The number of times an entity is quoted in the market, though not an input into the Markit liquidity score, is a useful metric to look at. It is a good indicator of interest in a credit, and sometimes thought of as a leading indicator. The chart below shows that the volume of quotes for the peripheral sovereigns has increased across the board. But the jump in quotes is less dramatic for Greece, which was already widely quoted. The increase is more prominent in the other countries, notably Ireland, Spain and Italy. It was around this period that fears of contagion from Greece became more acute, and the explosion in quotes tallies with the widening in spreads.
The Bafin ruling appears to have led to a drop in quotes on May 19, again supporting the bid-ask data that suggested a disruption in activity that day.