International Capital Market Features

banks, leveraged buyers entering the fixed income market and, most notably since 2015, the extraordinary expansion of central bank balance sheets which have – artificially – vastly increased the demand for government and corporate bonds in the extremely low-yield environment. It is worthwhile noting that, despite recent market growth, bond financing in Asia is still a low proportion of total borrowing compared to the loan market, certainly relative to the US and also Europe. In that regard the bond market in the region has significant unrealised potential both in G3 and local currency funding. ICMA spotlights the Asian bond markets now in an annual study which is supported by the HKMA.

A major theme through this cycle of broader bond market growth has been the explosion of green bonds and other ESG-related issuance which has now, positively, become a mainstay of the international markets, accounting already for around 15% of all annual international issuance. There is huge further potential upside to this market, now accounting for around US$1 trillion of supply annually and it is critical that industry standards, taxonomies, reporting and disclosure requirements evolve in a harmonised and interoperable way to foster market integration and accessibility. Initiatives such as the Common Ground Taxonomy between China and the EU and the work of the International Sustainability Standards Board on standardised baseline reporting and disclosure requirements are key to this.

Back to the broader market, significant market dislocations have seemingly become more frequent and visible in recent times, rightly prompting questions on market structure and resilience. The beginning of the COVID crisis in early 2020 initially led to strong demand for low-risk assets but very soon the desire for cash led to a sell-off in the most liquid instruments that were easiest to sell, including US Treasuries. This resulted in a major sell-off and precipitous drying-up of liquidity that sent shock waves through the bond markets globally and prompted major reviews and recommendations for improvements in market structure from official bodies such as the FSB and G20. This also manifested itself through significant redemption pressures on open-ended money market funds which pro-cyclically sold their most liquid holdings adding to market strains. New regulatory measures across the US, EU and UK are now focusing closely on the structure and operation of such funds to avoid a repeat in future times of stress.

The market has also been severely tested by the confluence of economic factors witnessed over the last two years. While the bond market has by no means been alone in being negatively impacted, the very sharp rises in interest rates from extremely low levels as central banks aggressively hiked rates driven by fears of runaway inflation and the warinduced energy crisis coupled with recession, as well as the impending reduction of central bank holdings of government and corporate bonds – also known as Quantitative Tightening or QT – had a direct effect leading to unprecedented spikes and volatility in government bond yields with dealers unable or unwilling to step in. Apart from all but the highest quality and most defensive credits we saw, as a result, a temporary paralysis in the primary markets globally, which depend on the transparency and liquidity in secondary markets to provide executable trading levels to support the price discovery process of new issues and give investors confidence. This was particularly the case in corporate, emerging market and higher yielding credits where liquidity temporarily became effectively non-existent. In Asia, for example, volumes fell nearly 50% compared to 2021. While higher rates were by no means unexpected, the speed of change caught the market off-guard, and it took time for equilibrium and a two-way market to re-emerge, helped by an improving outlook.

Against this backdrop, one of the major structural issues within the market has been the dramatic reduction of balance sheet liquidity provision capability in banks and trading operations as market outstanding volumes have grown. Bank intermediation remains critical in the bond market which – by its nature and very different to the equity market – remains largely institutional and wholesale in nature, dominated by dealer-driven over-the-counter execution.

Regulation, targeted principally at reducing counterparty risk in the banking system through both capital and liquidity coverage ratios, has increasingly constrained risk appetite and the capacity of banks to hold, warehouse and recycle risk assets. This has continued to the extent that, while global bond market volumes have almost doubled since 2010, dealer capacity has at best remained static. The prudential regulation has certainly been impactful and successful in building balance sheet resilience and reducing counterparty risk in the banking system, but at the same time it has led to heightened liquidity risk and the concentration and buildup of exposures in less well-regulated non-bank financial institutions. This became crystal clear for example in the recent LDI-driven turmoil in the UK gilt market precipitating the intervention of the Bank of England to stabilise market sentiment. Indeed, the involvement of central banks in secondary markets has been critically important on several occasions in recent times.

There continues to be a proliferation of ongoing regulation targeted principally at banks focused on areas such as trading book capacity, margin and collateral requirements and repo market activity, but now increasingly funds and money market funds are also being brought into the fold. Very careful consideration needs to be given to the unintended – and usually negative – consequences that application of regulation on one specific group of market participants or area of activity can have on the broader marketplace.

In response to this issue ICMA has created a liquidity and resilience taskforce with our members, with representation from all types of market participant, to try to pre-empt