Liquidity is as much an art as a science

World Finance spoke with the UK head of a liquidity provider about the forces shaping global liquidity, meme stocks volatility, and what crypto can teach us about the impact of regulation


David Barrett’s career in financial markets spans 35 years, during which time he has founded several consultancy businesses. With a background in foreign exchange, fixed income, commodities and derivatives, Barrett has held sales and trading roles for financial institutions including AIG, NatWest, ABN Amro and Nomura. He discussed with World Finance the impact of rising interest rates on global markets, the ‘lazy governance’ behind the US banking crisis, and how derivatives are carving out a role in sustainable investing.

How have recent market volatility and economic conditions affected liquidity in global markets?
There can be no doubt that liquidity in all markets has suffered in the first few months of 2023. Liquidity tends to be driven by participant confidence, high volumes, efficient price discovery and the staple ‘fear and greed’ effects, all of which have come under pressure of late. We have had so many newsworthy events in 2023 already that it is hard to know where to start but the core disruptor, in my view, has been the sharp rise in rates across the globe. All markets have spent over a decade learning to live with, and take advantage of, a near-zero rate environment. The rapid move in higher interest rates over the last 12 months has laid bare how ingrained those low rates have become.

The recent issues with US second-tier banks gave a perfect example of weak and lazy governance, slow-to-change regulation and technology-driven client optionality causing huge volatility in US regional bank shares and equal disruption in related bond markets. This one sector’s illiquidity snowballed over to markets in general, confidence was eroded, price discovery became extremely volatile, and the market’s fear became very evident. I suspect this cycle of disruption will continue as the full effects of higher rates spread across the economy and to the consumer.

What are the big trends driving the evolution of the derivatives market?
Technology has opened all markets to a much wider range of participants in recent years. Retail investor participation in derivatives markets has increased significantly, with the pandemic accelerating the process. Western markets have seen volumes increase by 15–30 percent and the Middle East and Asia Pacific regions have seen a 50–60 percent increase on some exchanges. This huge increase in demand has led to a wider range of derivative products across global markets.

More informed and active regulatory oversight is playing a large part in how derivatives can be sold, their impact on the underlying market, and which products are available in given regions. The crypto markets are a good example of regulatory impact leading to very fractured offerings and access. Until governments worldwide establish a more cohesive approach, their impact on this sector’s development will remain prohibitive. In future, I see the standardisation of derivative contracts having a huge impact on the sector.

How is the regulatory landscape changing, and what does this mean for derivatives?
All financial markets have seen unprecedented regulatory change over the past decade. Following the global financial crisis, derivatives had a front and centre seat in the inquisition that followed. While many market participants had huge failures in how they managed their derivative exposure, it was equally clear that regulators had not had the best experience either.

Regulators have pushed hard to remove as much derivative trading as possible from the OTC markets and push it on to exchange execution. While this consolidation has reduced large firms’ exposures to each other, the execution and cash usage associated with exchange trading will be a cause of concern to derivative providers and users alike.

Derivatives are not only created for mass use. Bespoke and extremely complex derivatives have been used extensively for risk management by a variety of end users. While this has been seen as a positive step, the financial crisis made it clear that, in times of market and counterparty stress, they can become very destructive. Regulators now demand much more clarity over how these types of contracts are sold and managed and the potential wider market impact. All of this will continue to make these products less available.

How are derivatives being used to further sustainability goals and what role can EBC play here?
The focus on sustainable investing has opened a new audience for derivative contract creation. The growth in focus on sustainable investing has led to a strong demand for and the development of sustainability-linked derivatives and other ESG-orientated contracts. In a broad sense, these products create exposure to, income from and/or a reduction to ESG targets for the end users.

Retail investor participation in derivatives markets has increased significantly

There are several broad types of derivatives linked to sustainability, including emission trading, renewable energy and fuel, sustainable credit derivatives, and sustainable-related CDS. These can be used by corporations and investors to manage, offset and benefit from sustainable exposure.
EBC, like many brokers and institutions, is listening to clients on how they would like to reflect their views on sustainability and ESG investing. As we grow, we will build out our offering to include access to CFD and derivative products that meet our clients’ requirements and risk appetite.

What are some of the challenges of managing risk in the derivatives market and how can these be addressed?
Managing risk in any product can generally be separated into five main areas: market or hedging, counterparty, liquidity, operational, regulatory and legal. Regulators have learned the advantages of making firms they oversee more conservative and better capitalised – even if those firms do not always see it the same way. Increasing the capital buffers and central exchange-driven clearing helps with stability but has dramatically increased costs for all market participants.

Counterparty risk management is clearly reduced in exchange-cleared derivatives, but the drive to push trades this way has made innovation and bespoke trades more expensive and more complex to manage. It could be argued that this is to the detriment of end users and that we should not lapse into thinking using central clearing counterparties (CCPs) comes without risk. The GFC and Covid-19 both showed how heavily correlated markets are now and CCPs are only as strong as the clearing members.

It is important to mention operational risk as well. It is the backbone of any firm, as well as a complex ecosystem of people, compliance and governance. Regulators have concentrated more on this area of late and, as the reliance on technology and remote transactions increases, the complexity of managing operational risk increases. As we saw during the meme stocks volatility, some of the very fast-growing retail trading platforms offering derivative contracts on the underlying stocks had massively underestimated the required build-out in systems and experienced staff to deal with the surge in volumes. All firms would do well to take note.

What effect has the war in Ukraine and the subsequent European energy crisis had on energy derivatives?
Initially the war in Ukraine caused massive disruption in natural gas, oil and agricultural markets, led by real-time and supposed future delivery interruptions and then followed up with heavy political sanctions. Prices increased substantially but markets have calmed somewhat as the war became more drawn out and supply disruption is managed. European governments and markets reacted to the supply disruptions by looking for energy elsewhere and accelerating the move into renewable energy. The flexibility and availability of derivative contracts in global markets aided these changes in focus. The accelerated focus on renewables could bring forward Europe’s decarbonisation goals by five to 10 years. This could increase the activity in ESG- and SLD-related derivatives, particularly those linked to offsetting carbon emissions.

How have investors coped so far with extreme price volatility?
Markets have shown remarkable resilience to supply and price volatility and have adapted well to the changes they brought about. The markets’ ability to re-route Russia’s exports, find supply and demand from other markets, and navigate the political fallout has helped investors cope with the price volatility.

What has EBC been doing to help clients manage risk and improve liquidity specifically with this issue in mind?
Volatility and leverage work both ways for clients. As a regulated firm, we are acutely aware of our responsibilities in helping clients understand and manage both. We have tier-one liquidity relationships that help us manage how we access pricing and how we tailor that pricing to each client’s needs. Liquidity is as much an art as a science. We deliberately use fewer, but better quality, providers so that our relationships with them remain close and beneficial to all. Using market-leading technology to deliver liquidity to clients is just as crucial, and our operational tools give our clients the information they need to manage their trading exposure and risk.

The EU has brought in measures to ease liquidity stress and reduce extreme price swings – have these had the intended result?
I think on a broad view they have been effective. Demand has reduced, particularly in countries like Germany, which cut gas consumption by an average of 23 percent in the second half of 2022.

Considering how reliant they have been historically on Russian gas, this is a very constructive result. The wider group of countries have started to respond but it has to be acknowledged that progress is not even. The cap of market revenues has been more controversial. The inclusion of renewables and nuclear energy in the cap was not received with universal praise, with many seeing it as counterproductive to longer-term goals. It feels like the true effects of what this part of the policy can achieve will only be seen after a longer period. Price setting, while politically popular, has a potentially substantial cost that goes with it.

From a derivatives perspective, the EU introduced a series of measures to curb price volatility, via a dynamic price limit for transactions in the TTF, along with an extreme price spike cap mechanism. The market has not had to lean too hard on these measures as the price reductions already seen have lowered the pressure.