State Street On Liquidity Black Holes

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.