The Growing Importance Of Securities Markets
By Shane Worner, Senior Economist, IOSCO
It is an interesting time for the financial markets. As the impacts of the most recent financial crisis recede into the background, regulators globally are still in the process of reforming the financial system. Additionally, markets are in an unprecedented position; awash with liquidity. No longer are prices for some asset classes set by the economic principles of supply and demand, rather, central bank operations now act as a market-clearing price.
Many jurisdictions continue to maintain a highly accommodative stance on monetary policy. In the US and Europe, the central bank policy rates remain at levels close to zero. While this accommodative monetary policy is great news for bank profitability, unfortunately loan provision to the real economy, characterised by loans to non-financial corporations, has been declining. Obviously, liquidity is not a ‘silver bullet’ if it does not reach where it is needed the most – the real economy.
It is not all bad news, however. The recently published IOSCO Securities Markets Risk Outlook 2014-2015 highlights that much of the funding slack has been taken up by securities markets, with the importance of equity and debt funding markets growing. Globally, equity markets have shown strong growth in initial and special public offerings; in debt markets, corporations have been increasingly tapping bond markets for operational purposes. In 2014, the level of corporate bond issuances is expected to double that of 2005.
Additionally innovation is taking place through such funding initiatives as crowdfunding and peer-to-peer lending. Funding volumes through such platforms stand to exceed US $12 billion by end 2014. Although a drop in the ocean when compared to the scale of bank lending, crowdfunding is an example of innovation that is able to channel funding to where it is needed in the real economy.
This extraordinary liquidity is also flowing into more traditional asset classes. Equity market levels have been trending well in many economies. Traditional valuation measures, such as CAPE and Tobin’s q, indicate that US stock valuations are above historical averages and Europe is at fair value, while Asian indicators show an undervaluation by historical standards. In corporate bond markets, spreads to US treasuries are compressed to historical low levels.
Not surprisingly, given the liquidity effects on the return in interest-bearing assets, there is a search for yield or ‘disregard for risk’ phenomena taking place in markets. Issuances in products such as high yield bonds; sub-ordinated bonds; convertible capital (CoCo’s) covenant-lite loans and payment-in-kind (PIK) bonds are at all-time time highs. In effect, investors are showing a willingness to trade away credit hierarchy protection for increased returns.
This is coupled with increased levels of leverage and complexity in the system, which is becoming apparent in equity, bond and securitised markets. Margin debt is at an all-time high as participants leverage their positions into equities. Some of this can be explained by the level of financial leverage in hedge funds, which is also slowing creeping up. Since the onset of the crisis many hedge funds have chosen to retain unencumbered cash on their own account rather than placing it with prime brokers. In debt markets, there is an increase in both financial and non-financial bond issuances. Interest in securitised products remains the main story in Asia, where issuances have increased since 2008.
Although securities markets have stepped in to substitute the reduced bank-led funding of the real economy, many questions remain. One of the concerns expressed in the IOSCO Securities Markets Risk Outlook is how resilient the financial system is when interest rates inevitably increase.