One week ago, when we first previewed this week's infamous $60 billion pension fund rebalancing out of equities and into bonds which resulted in historic market gyrations, and a violent snapback in the S&P from what was shaping up to be the worst December on record for stocks, we warned that while the buying would "finally be some good news for the bulls" however "the problem is that the sudden deluge of last minute buying may simply be too much for the market to handle, as liquidity has collapsed to the lowest level on record" and as a result "investors and traders looking for a desperately needed respite from market gyrations may have to deal with yet one more "seismic bout" of volatility."
That's precisely what happened, and while many are still trying to understand the cause behind last week's market violence which prompted comparisons to watching the cult classic Pulp Fiction, where chaos is the only constant, the bigger problem that has emerged is a far greater one: how does one trade in a market in which, as we showed last week, liquidity has dropped to the lowest on record?
Practically speaking, the problem is simple as Bertran de la Lastra, CIO at Bestinver Gestion summarized: "If you go into the large caps and you try to do a significant trade - let’s say in a big fund company of $200 billion you’re trying to do a $50 million clip, a $100 million clip – you should be able to do it fairly quickly." However, "the reality is that you may have to be working on it for a few days."
Indeed, as Bloomberg writes this morning, as the decade-long equity bull run is ending, liquidity risk - the possibility markets will struggle to absorb selling demand without large price moves - has been mentioned by everyone from Goldman Sachs to Donald Trump. And while worries like that aren’t new - we have been discussing the ascent of algo trading, the market's fragmented and often broken structure and the collapse in market liquidity ever since 2009 - and predictably increase when markets are in free fall as they have been recently. "rarely have they gotten a bigger test than in the last few weeks."
And, as Bloomberg adds, few topics on Wall Street get blood boiling faster than liquidity, particularly when worries about exchange structure are dragged in, as they are by critics who decry the supplanting of human market makers by machines. While those arguments may never be convincingly decided - at least until we have the infamous market crash which sends the S&P plunging without snapping back as Goldman's co-head of trading described his worst market nightmare back in June - a few traders shared their thoughts on what they saw over the last few weeks amid some of the toughest markets in a decade.
Delores Rubin, senior equities trader at Deutsche Bank Wealth Management:
“I’ve had my normal activity, I haven’t had anything out of the ordinary from what I would see this time of year in terms of being able to trade in and out of names that I have on both sides of the market,” she said. “It’s really about the timing. If you happen to have a huge block to move, and it’s during one of those times that there’s other movement in that same direction, it does become more difficult.”
Jake Rappaport, head of equities at INTL FCstone Financial:
“We’re having a sell-off, but we still have buy orders. With the tax selling and the year-end coupled with the political turmoil -- it’s scary, but I think it’s too soon to tell if people are going to stay on the sidelines,” he said. “Ultimately, they have to make a choice. Is the market giving them the price they’re willing to transact? ... The panic ‘Get me out’ trades, we just haven’t seen them yet.”
Mike Beth, vice president for equity and derivative trading, WallachBeth Capital:
“As the markets has been getting more volatile, we have been seeing an increase in the number of people wanting to get rid of large blocks as a whole, basically take out the timing risk of the stock moving. There are two things that we’re looking at every day, market impact and timing risk, and you want to find a happy medium between the two. When the market’s moving around like this, it increases people’s urgency to get rid of large quantities at once.”
Joseph Saluzzi, Themis Trading LLC partner and co-head of equity trading:
“By definition when volatility picks up, liquidity is thinner, It’s not new. In this time it’s been more dramatic -- I can judge that by the depth of liquidity in a particular quote. Maybe you’re used to seeing 5,000 shares on a bid -- you’re now seeing maybe half of that, or lower numbers. People are willing to supply less liquidity because they don’t want to get run over.”
While to traders the liquidity situation may not seem dire just yet, as they are forced to trade in this market day after day, and thus the changes appear incremental and allow gradual habituation to the new reality, the reality as we noted over a week ago is that according to a Goldman analysis, the depth of the S&P 500 futures market has thinned by 70% over the past year to the lowest on record as single stock liquidity has fallen 42% over the past year to some of the lowest levels since the crisis.
We laid out the threat of plunging liquidity as follows: "ever feel like the smallest order gets to push the Emini around like a toy? It's not just a feeling: it's the truth, because as shown below, not only is the Emini futures top-of-book depth worse now than it was in the highest-vol weeks of October, it is also worse than it was during the record VIX surge in February. In fact, the top Emini orderbook has never been worse."
To Goldman's John Marshall, the problem of collapsing liquifity isn’t structural or related to HFT or ETFs, but can be explained by simple risk aversion among professional investors rather than the growth in electronic trading, which however is a very different view from what Goldman's Chief Markets Economist Charlie Himmelberg, said back in May when the Goldman strategist warned that HFTs – due to their inability to process nuanced fundamental information - may trigger surprisingly large drops in liquidity that exacerbate price declines, and result in flash crashes. Himmelberg highlighted the growing market share of HFT and algorithmic trading across all markets, and warned that the growing lack of traditional, human market-makers has made the market increasingly fragile.
One month later, Brian Levine, Goldman’s co-head of Global Equities Trading, eased back on the bank's criticism of HFTs, but doubled down on his concerns about the illiquid market, and in an internal Goldman interview published this past June, one of the world's most influential traders said that there is one aspect of that the current broken market structure that keeps him up at night. As he admitted in the interview, “what’s more worrisome to me is a real flash crash, which I define as a situation when the market “breaks.”
This is how Levine described his own personal trading nightmare, one in which the crash is not a “flash” and the market simply breaks:
The data is wrong, everything trades at dislocated prices relative to the NBBO, and everyone—justifiably—widens their spreads. That happens almost every time there’s volatility, largely because message traffic increases dramatically. This is due to the fact that the opportunity set is greater and there’s no economic disincentive for sending messages to the market, so more electronic orders come in. This slows the system, widening spreads and generating price dislocations, which triggers even more orders and compounds the delays—a predicament that is only further exacerbated by the fragmentation of the equity markets. As this happens, stocks may trade outside of the NBBO briefly in millisecond or microsecond increments, constituting what I consider a genuine flash crash. All of this becomes a negative feedback loop that causes more volatility.
Interestingly, if you define a flash crash by the percentage of executions that took place outside the NBBO, one of the largest ones occurred in 2008 after the first TARP bill failed, according to internal analysis we did a few years ago. And the market didn’t snap back, with the SPX closing down 10% on the day and on its lows. I think that may have been why there wasn’t talk of a “flash crash” afterward, but clearly the market structurally failed pretty badly that day, too. This suggests to me that, in a situation with actual bad news, the current US market structure may not be able to handle it, and there could be a downward spiral.
In other words, there will come a day “with actual bad news” when the selling onslaught is so broad, not even BTFD HFTs will be able to resist the sudden avalanche of selling. That’s the day when the increasingly fragile market, one in which “liquidity is the new leverage” will officially break and stocks will “trade outside of the NBBO constituting a genuine flash crash” in a “negative feedback loop that causes more volatility.” A selloff from which there will be no “snap back.”
While the apocalyptic liquidity scenario laid out by Levine was precisely what prompted broad market anguish in recent weeks, we are not there just yet, and the more benign explanation may suffice for now as evidence of risk aversion is everywhere as more than $5 trillion has been erased from U.S. stock values in the last three months as the S&P 500 slid within points of a bear market.
At the same time, share totals on U.S. exchanges have regularly exceeded 9 billion in the last few weeks, which skeptics highlights as an indication that liquidity is actually relatively stable. It's not just common stock: the average volume in puts and calls surged 22% this year as the S&P 500 Index endured two corrections and a near bear market. At 20 million contracts a day, trading is poised to surpass the previous record of 18 million reached in 2011, data compiled by Options Clearing Corp. showed.
That, explanation however does not satisfy the critics who have expressed concern that structural changes since the crisis have made the market more vulnerable, and this is where some shift blame away from HFTs to ETFs.
As Bloomberg notes, a common complaint is that passive funds sap liquidity when pressed into "harmonized action" and that their selling overwhelms high-frequency market makers - a theory that academic research is skeptical of. Other critics cite post-crisis regulations that made it costlier for banks to hold positions.
“If you don’t play the market by trying to value one stock versus the other and those kinds of things, but by being in and out of the market, the minute you have a shift in the sentiment then it can reduce significantly the liquidity in the market,” said Francois Savary, chief investment officer at Prime Partners SA in Geneva.
Others blame a different culprit yet, namely the market's changing microstructure: Spreads have widened because of the market’s changing structure, according to Aram Green, fund manager at ClearBridge Investments in New York, though he doesn’t agree that liquidity has worsened.
“You’ll see a price on your screen of a stock down 30 dollars and you go to buy it and there’s no volume to buy it. And next thing you know it’s back to flat,” he said. At the same time, “we decide that we’re going to get out of half a million shares, and the thing only trades 300,000 shares a day and we put it out there in some dark pool, and it’s gone in."
Whatever the reason behind the record collapse in liquidity, whether it is the dominance of HFTs who all liquidity when it is not needed and soak it up when there is virtually non, or broken markets with countless exchanges as algos scramble to frontrun each other in normal days but lead to a trading panic during volatile days, or the lack of active market makers due to bank regulation which has forced dealers to shore up liquidity, or ETFs which collectively all decide to sell at the same time overpowering the market's thinning top-level liquidity, or simply the result of central bank balance sheet shrinkage, the reality is that the problem is not going away and will only get worse as the bear market unfolds and as market volatility explodes.
Which, in turn reminds us Bill Blain's ominous warning for 2019:
As the unwind continues, Financial Assets inflated by the free-money effects of QE are still finding new equilibrium valuations. Markets will remain volatile. Tech change and supply fundamentals will continue to shock us – look at oil prices for an example; turning a good year for oil and energy into a question market. Or look at how iPhone sales in India have fallen off a cliff as people buy cheaper phones that do the same – commoditisation!
The thing that scares me most is liquidity – the lack of it.