AS markets nervously await the US Federal Reserve's first step in raising interest rates, the Institute of International Finance (IIF) in Washington is worried about the danger of further "flash crashes" on stock exchanges and of "panic selling" setting in among alarmed investors.
This, together with concerns over the rapid and huge buildup in emerging-market corporate debt, lies behind repeated warnings issued by the IIF in recent weeks, the institute's executive managing director Hung Tran told The Business Times.
Secondary market liquidity has been profoundly affected by structural and regulatory changes in securities markets and the system is still largely untested in times of crisis, he said in an interview on the sidelines of the International Monetary Fund and World Bank annual meetings in Lima, Peru.
He said: "The challenge now is to understand whether if the Fed were to normalise monetary policy - which they will either in October or November or in first quarter of 2016 - how would the impact be handled by trading systems.
"A lot of investors have been piling into fixed income instruments, corporate bonds and high yield bonds and if they needed to rebalance their portfolio, how would that be transacted. Would it give rise to imbalances that cause flash crashes, or would it be implemented fairly smoothly."
The concern is not just theoretical, said Mr Tran, pointing to the incident on the New York Stock Exchange in August when the prices of some blue-chip companies crashed by 20 per cent within five minutes of the opening.
These are instances "where imbalances between buy and sell orders cause very large price movements independent of fundamentals", he said. In periods of market stress, there is a tendency for "price gapping" and that could give rise to a crisis or "panic-selling" situation.
There have been changes in provision of market liquidity since the 2008 global financial crisis, he noted. "In the past it was a system driven mainly by market makers as intermediaries who basically took the risk on their own balance sheets to provide facilitation for investors."
It has moved now to a "hybrid" model whereby traditional market makers have been partly displaced by a system where buyers and sellers of securities need to be "matched" before transactions can take place. This has narrowed trading spreads but it has also taken "depth" out of the market.
On emerging-market corporate debt, Mr Tran said: "The buildup is worrisome because it is large - US$23.7 trillion outstanding for the 18 emerging-market countries that we look at in the non-financial corporate sector. The buildup has been very swift. From 2008, it increased by almost 30 per cent of GDP, so now it is around 90 per cent of GDP of those countries, which is way ahead of US corporate sector debt."
Out of that, 18 per cent is foreign currency debt and the bulk of that is in US dollars, Mr Tran said. "So, if the dollar strengthens against local currencies, then the service of that debt will be much more onerous and more painful for borrowers."
Borrowers are already under pressure because emerging-market growth is going down, corporate earnings are going down, and both are correlated with the downturn in world trade and commodity prices.
This points to "more corporate distress in emerging markets and a rise in non-performing loans", he said. Banks can probably cope with the situation for now but if this lasts "for a long time, then it will have contagion from the non-financial sector to other sectors".
The main impact of the debt buildup "seems to be on the corporate sector", Mr Tran added. Companies "cannot undertake capital expenditure and that feeds into slower growth".