In this new post-crisis world, there is no doubt that the ability of free markets, when it comes to efficient resource allocation, has been challenged. 
There are still considerable challenges for global markets – rising populism in the developed world is leading to economic policy shifts, while leverage in the global system is still very high and, in many cases, has increased further.
New regulations and increased capital buffers implemented post-2008 have made banks safer to try to prevent a repeat of the financial crisis, but these changes have also generated unintended consequences.
It is this latter point which is the most unappreciated, yet equally – if not more – problematic, for financial markets going forward.
Liquidity shortage is causing fixed income market fragmentation
Central banks have become key players in asset markets (especially fixed income) and their involvement has raised a number of new challenges for investors.
Meanwhile, the new regulatory backdrop has seriously damaged the ability of broker/dealers to intermediate in secondary fixed income markets, leading to a to a “fractured liquidity” environment.
A survey of the 13 largest European bond market makers by the European Commission recently confirmed they believe regulations, especially capital requirements, are impacting their ability to execute their responsibilities. Banks have to contend with higher capital requirements and more conservative risk definitions for use in calculating the capital required to support assets. This all makes it more expensive to hold corporate bonds.
Specifically, banks are now acting as brokers rather than true market makers. When market makers are restricted in their ability to intermediate in secondary markets, this causes a liquidity shortage and a fragmentation of the fixed income market.
In the background, corporate bond inventories have come down in Europe as well, although probably less so than in the US. When looking at the implications on market behaviour, a European commission study shows that average holding period by investors of both HY and IG bonds has almost doubled over the last 6 years, showing the deep impact these challenges are having on investor behaviour.
Investor herding could lead to big market shock in downturn
Data from the IMF data shows that ‘herding’, or the commonality in positions held by investors, has gone up significantly. We have also seen the tracking errors of the largest asset managers in certain asset classes come down, which means that they are gravitating towards very similar portfolios.
This is down to the widespread use of benchmarks and portfolio allocations based on market-capitalisation weightings (especially in fixed income).
In fixed income, market capitalisation-weighted portfolios give a higher weighting to the most indebted issuers, regardless of their capacity to repay their debt. In addition, quantitative easing has had a significant impact on who the most indebted issuers are.
This convention is now leading investors into already crowded positions, which exacerbates their exposure to fractured liquidity in bond markets.
This means that if there is a shock to the market when everybody is on the same side then that creates potential problems. On a day-to-day basis a big asset manager can trade with another big asset manager, which is seen as a potential solution to mitigate the impact of weak dealer activity, but when there is herding, that causes a problem in a stress situation.
Italy was a warning, but investors await the final trigger
The current state of the Italian government bond market is a good example of fractured liquidity and how this can become very dangerous, whereby even a moderate shock was amplified by the lack of liquidity in May, to a level comparable to what we saw in the wake of the Eurozone crisis. When market prices become a political issue, this could have ramifications for the design of the European Union as a whole.
These big shocks do not creep onto us; they are usually out there in the open.
What is unknown is the timing of the shock or its trigger. This time around, it is the very easy monetary policy and the unintended consequences of heavy regulations.
From an investor perspective, sustained easy monetary policy has distorted economic signals. It has distorted the link between fundamentals and economic signals. This adds to our work because we have to be careful whether that link is re-established or not and the consequences.
Salman Ahmed is chief investment strategist at Lombard Odier Investment Managers. The views expressed above are his own and should not be taken as investment advice.