State Street On Liquidity Black Holes

Tyler Durden's picture

Liquidity, as frequent readers know, is a fascinating topic to Zero Hedge. Liquidity black holes, as one would imagine, is doubly so. However, when a firm like State Street, which is at the heart of the multi-trillion dollar stock lending skeleton of the market discusses both of these concepts, one must pay attention. The below report is a State Street presentation from 2003 discussing what happens in those episodes when liquidity disappears and how that impairs all other axes of proper market function.

Of notable attention is the following section of the report:

The presence of liquidity problems in the largest of markets suggests that liquidity is not about size, but diversity.

In an illiquid market the same size of sell order will push the market down further than in a liquid market. Imagine a market where there is a large number of market participants, using the exact same information set, in the exact same way, to trade the exact same financial instruments. When one buys they all do and vice versa. Market participants would face volatility and illiquidity when they came to buy or sell. This would not be reduced by having more players, only by increasing the amount of diversity in their actions. (Indeed, on these assumptions it is possible to show that the bigger the market was, the less liquid it would be). Now imagine a market with just two players but with opposite objectives or opposite ways of defining value. When one wants to buy the other wants to sell. This market is small, but the price impact of trading would be low and liquidity would be high.

The referenced diversity is a crucial concept in today's market where
an unprecedented amount of market trades occurs in undiverse dark and
HFT pools. As Goldman is becoming the primary conduit of trading
(whether principal or agency) in virtually all markets, the risk of a
massive liquidity drain becomes exponentially larger, and the risk of
an exogenous event approaches LTCM and Lehman levels. It is this key risk driver that regulators should be focusing on,
instead of chasing and attempting to punish the perpetrators of the
most recent market crash (we are not saying they should not, but they
should prioritize and now should focus on what is
most critical to maintaining a functioning market topology). The Too
Big To Fail is a psychological construct which however does not have
parallels in the market. Once Goldman reaches a tipping point of
eliminating liquidity diversity, the potential fallout escalates. This
is precisely the realm in which any x sigma events will occur in the
future. And nobody seems to care. 

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Anonymous's picture

Sorry off the topic but related:

Every Breath Bernanke Takes from Columbia Biz School:

deadhead's picture

Thanks for the article, great read and informative (though i have forgotten all the math stuff when the squiggles and  non numbers are utilized, lol!).

Anonymous's picture

Damn It Feels Good To Be A Banka:

Anonymous's picture

interesting thesis whose policy implications
are not entirely clear.....i gather from the
article that the author believes that regulatory
agencies have systematically induced
homogeneity in decision rules across diverse
actors but it is not
clear to me where that is occurring and to what
examples would be helpful.

if the regulatory agencies have not done so, then
how exactly is diversity supposed to be cultivated
without creating other equally undesirable

diversity in decsion rules is probably inherently
anathema to regulators who often prefer
uniformity in policy and outcomes because they
usually abhor complexity and freedom. hence their
zeal in regulating markets to death. and yet they
fail spectacularly in enforcing regulations
regarding capital ratios,
ponzi schemes, front running, market concentration
and a host of other evils for which they have
been charged to foil.

it may be sufficient to recongize that liquidity
black holes exist and provide hedging solutions
to compensate than to suppose that diversity
can be enforced by fiat.

it's worthy of further discussion.

Anonymous's picture

Ok. This is how the quants got clobbered. What kind of regulatory actions should be taken to increase diversity?

Gordon_Gekko's picture

"The Too Big To Fail is a psychological construct which however does not have parallels in the market."


Truer words were never spoken. And extremely well put.

Anonymous's picture

Apocalypse Now-

Yes, too big to fail is clearly a state sponsored monopoly that sponsors the state (campaign contributions & lobbying).

I wonder how many of our bailout tax dollars will be used to repay those beneficent politicians.

Anonymous's picture

Apocalypse Now-

The wise know we are in a slow motion collapse and that macroeconomic conditions and demographics outweigh everything else.

Quotes like "we are out of money" from Obama tell the truth, and I think they are trying to ensure an organized fall instead of panic.
They are doing everything to save it, and I think they rallied the economists and talking finance heads to pick a date to just state the recession is over in an attempt to stimulate spending (back to normal) and convince businesses not to lay off any more workers. We are in a deflationary spiral, they want to pull the plane up, and are willing to state untruths (greenshoots) for a "good" cause.

What if the powers that be knew this diversity principle (likely) and also knew that if there was a fear of deflation all logical investors would pile into the few assets that perform well in deflation at the expense of all other asset classes killing diversity and liquidity at the same time and driving up the price of those few assets due to demand? Might they use their digital zeros and dark pools to buy up riskier assets (SLP) since investors always look at historic performance (although this is like driving your car forward by looking at the rear view mirror), it would avoid everyone piling into gold. This buying would also look completely illogical which is our current random walk situation. It could be worse than we think and the bots could be trying to save the system counter-intuitively (like Excel solver)?

Life will go on, although quality of life will change on the whole.

Anonymous's picture

Liquidity is provided by retail investors who buy when institutional investors sell and vice versa.

Where all institutional trades act in the same way potentially causing the so called liquidity black holes, there is always CNBC to stoke enough bids and asks from ma and pa who we all know have no way to define 'value'.

Anonymous's picture

This site is a fucking joke run by a bunch of conspiracy loving idiots that have never made any real money trading stocks. It's read by another group of pathetic idiots who lose money and can only blame conspiracies for their losses.
High frequency trading benefits the marketplace. It is only possible because the costs of trading are so low now. Did any of you actually trade before the markets were entirely electronic? Do you remember what it was like to deal with asshole specialists that had an informational edge? The same assholes who made billions fleecing the public? The same goes for NASDAQ and the market makers? High frequency boxes do not get any quick peek at incoming order flow like their manual predecessors. Most of them simply front run and are market neutral.

Marla Singer's picture

Glad you're enjoying the site!

Anonymous's picture

just because someone thinks that there is a
conspiracy does not mean that there is not one
any more than just because you're paranoid does
not mean that someone is not out to get you.

if the trading is all market neutral then why
would goldman sachs make huge profits on this
type of trading? it clearly has information
which others do not have to be exceptionally

hft does not provide liquidity because it does
not provide diversity - it only intensifies the
direction of trade.

the conspiracy is that gs owns a huge % of
program trading, one definition of market
cornering or manipulation. that huge ownership
millitates against liquidity.

i wouldn't say that you are entirely wrong but
there is more to the story.

Ben_the_Bald's picture

And the solution is? ....