Anyone active in derivatives will tell you that market liquidity suddenly became very challenging in March, as the coronavirus pandemic rapidly escalated across the globe. They’ll also tell you that conditions improved as central banks began pumping trillions of dollars into financial markets. What’s less understood is what sparked the disruption in liquidity in the first place, what impact it had, and what government measures were most effective in reversing the situation. To help shine some light on those issues, ISDA teamed up with Greenwich Associates to publish a new report that takes a detailed look into what happened.

The report, published earlier today, is based on a survey of 172 buy- and sell-side market participants, and reveals just how prevalent the challenges were. As the coronavirus outbreak morphed into a full-blown pandemic and successive countries entered lockdown, there was a sudden scramble for cash from corporates and investors, which put pressure on bank credit facilities and resulted in strong selling pressure in other markets.

Respondents reported a decline or large decline in liquidity across product sets as a result, with block trading activity in non-cleared interest rate swaps particularly hard hit – a finding backed up by other recent ISDA research. Liquidity issues were also reported in multiple regions, although the impact doesn’t appear to be uniform – for example, 96% of market participants in the UK pointed to a decline or large decline in interest rate swap liquidity before central bank intervention, versus 76% in the US.

While the spread of the coronavirus pandemic and concern about the economic impact was clearly the root cause of the market turmoil, survey respondents pointed to a number of specific economic and financial catalysts for the deterioration in liquidity. The top financial factor was perceived to be the reduced risk appetite of banks. This was closely followed by the sudden need for short-term funding by corporates, as firms looked to shore up balance sheets amid the coronavirus lockdowns.

Market participants responded by trading in smaller sizes, a strategy widely adopted by buy-side respondents before the central bank interventions. End users also relied more on trading over the phone – a tactic identified by 31% of buy-side respondents.

For their part, sell-side firms reported a number of obstacles that hindered their ability to provide liquidity in derivatives markets, including one-way flow, increased volatility, the breakdown of common basis trading strategies and high short-term funding costs. These varied depending on region, with the cost of short-term funding cited as a bigger issue in Asia and the EU than in the UK and US. Together, these forced a widening of bid-offer spreads, which was cited as a response to the crisis by 49% of sell-side institutions.

Government intervention was seen as an important factor in restoring market liquidity, with 60% of UK participants reporting an improvement or large improvement in interest rate swap liquidity following the central bank action. More than two thirds of all respondents characterized US Federal Reserve and US Treasury action as effective or extremely effective, with the Fed’s temporary repo facility for foreign and international monetary authorities cited as the most important government intervention.

Despite the liquidity challenges, it’s important to note that derivatives markets continued to function. Banks played an important role in supporting the transmission of central bank interventions to the real economy, providing critical stability. Key infrastructures, including clearing houses and trading venues, operated largely without issue and markets remained open in all but a couple of cases. To some extent, this can be attributed to the regulatory reforms of the past decade. When asked about the impact of those reforms, the top response was that they ensured the banking system was sufficiently capitalized to weather the crisis. The second most cited response was that they reduced the capacity of banks to provide liquidity and to extend their balance sheets to business.

As markets start to normalize, regulators will likely start look closely at the period of disruption to determine if a policy response is necessary. Analysis like this is an important starting point in understanding what happened and why, and in ensuring that derivatives markets remain safe and efficient.