My FT Op-Ed: Beware pools of liquidity: they could be a mirage

I recently wrote an op-ed for the FT on a topic that I feel is neglected by many. The FT link is here and here’s the piece:

E-trading, shrunken market-makers and retreating central banks is a triple threat

A cynic would say that investors know the price of everything and the value of nothing. But the reality could be much worse because they may not even know the price. For decades, investors, policymakers and academics have taken financial market prices as the critical gauge for the overall expectations on the economy and company performance.

Of course, some acknowledge that markets can get carried away as bubble dynamics develop, and ever since the 2008 financial crisis a veritable industry has developed, trying to identify the next bubble to burst. Indeed, not a day goes by without Cassandras calling for the imminent collapse of China under a mountain of debt, or the break-up of the eurozone or America’s corporate balance sheets buckling under years of heavy debt issuance.

Yet, through all of this, the sanctity around the market price has remained. Most don’t question whether basic formation of market prices is faulty. What if market gyrations are less to do with shifts in expectations on the economy or company performance, and more to do with participants coming to terms with a less well-functioning market?

The past few months have given us clear glimpses of this. The starkest was seen in currency markets at the start of the year. The Japanese yen experienced a flash crash, when it jumped 4 per cent against the US dollar in one day. This was all the more surprising because the trigger was apparent selling of an emerging market currency against the yen, which ended up affecting the trillion-dollar-a-day yen market.

More generally, the final month of 2018 saw markets suffer extreme moves in the absence of much fundamental news. At one point US equities were down more than 15 per cent, before reversing those losses over the subsequent weeks. At the same time, interest-rate markets swung from an anticipation of increases in Fed policy rates for 2019, to cuts. All of the moves, from currencies to equities to interest rates, were more likely caused by liquidity problems than shifts in underlying fundamentals or credit risk.

So what has caused this growing fragility? Three factors stand out. First, the rise of electronic trading on both the sellside and buyside, with robots replacing human market makers to provide endless streams of prices. Buying and selling a security can be done at the click of a button. Not only that, but entities that never made markets in a security can now plug into the streaming prices of a larger liquidity provider and label them as their own. The glitter of those prices and the apparent multiplication of market makers gives the illusion of abundant market liquidity.

Second, the role of banks has been reduced in the market-making process. Thanks to the scars of the 2008 financial crisis, poor behaviour of traders and increased regulations, banks have been squeezed. In the past, they could more easily hold a security if they could not find a buyer in the market, but now with balance-sheet constraints, they have to sell into thin markets, which could exacerbate price gyrations. Moreover, a less discussed, but likely more important factor, is that new restrictions on bank dealers communicating with each other have probably resulted in information vacuums at times of high market stress. Market makers could withdraw from the market out of caution.

Third, the significant presence of central banks in financial markets after their large-scale quantitative easing programmes has introduced an apparent buyer of last resort. This, in turn, has made market participants believe they can sell more easily than they really can.

The result of these forces is that in “normal” times, liquidity — or the ability to buy or sell a security — appears ample. Investors have endless prices flashing before them, there is no need to speak to another human and central banks will always intervene if necessary. However, when “abnormal” times hit, this liquidity quickly vanishes. The streaming prices stop as the robots freeze; human traders are constrained to act; and central banks are too slow to buy or have shifted policy to stop acting as a buyer of last resort.

Today’s biggest risk, then, could be that investors are underpricing liquidity risk. They think their assets are worth one thing when they look at streams of prices, but they may actually be worth another when they go to sell them. It also means that sharp market moves could be less reflective of the credit or business cycle and more reflective of this repricing of liquidity. This provides an additional challenge to central banks as they unwind their easing programmes. It is now time to add another worry to the list: the unravelling of the market liquidity illusion.

Bilal

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