Thus, in the wake of the financial crisis there has been a substantial increase in the intermediation of credit via financial markets rather than long-term on the balance sheets of banks, involving both the supply of new credit to borrowers and the absorption of assets coming out of the banking system, as banks reduce their balance sheets. Over the same period, there has been a fundamental and rapid change in the microstructure of financial markets – the organisation of how they work. Electronic platforms are increasingly used in a number of major financial markets (notably equity and foreign exchange markets). As part of that change, automated trading – which is a subset of electronic trading using algorithms to determine trading decisions – has become common in those markets. And, within automated trading, there has been growth in high frequency trading – which relies on speed of execution to get ahead of other market players. 3 While electronic trading has contributed to increasing market efficiency and probably reducing transaction costs, there are also risks that arise from trading strategies that are flawed, or where in constructing the strategy not all possible outcomes were considered, including the ability to trade large blocks. To recap, the last two decades have seen major changes in the financial system. These have, in turn, shaped the impact of the global financial crisis and its aftermath.
One element of this is the response of regulators to the financial crisis (to which I will return later), while the other is a product of the rapid development of technology and trading strategies. The effects have probably been offset to some degree by beneficial influences from central bank monetary policy actions which have increased market liquidity. Measures of risk that reflect the overall demand for and supply of financial assets, including liquidity risk premia, remain low by historical standards, notwithstanding recent events. In part, this likely reflects the continued intended effects of monetary policy setting and the communication of policy looking forward. This has, as intended, provided an incentive for risk-taking by investors, and thus the market environment has been conducive to the so-called “search for yield”. But, as described, underlying conditions in financial markets suggest that the current situation could be fragile. 5 Shocks that might prompt large-scale asset disposals are of particular concern. The global asset management industry is both large in size in its own right and relative to the size of the commercial banking system. A key issue is the degree to which asset managers (or shadow banks) typically offer shortterm redemptions against potentially illiquid assets. This capacity to realise assets without unwanted disturbance to financial markets is therefore critical and is shaping the work of authorities. The risk is inherently global in nature, thereby suggesting that internationally– coordinated policy action is the preferred outcome where necessary.