Credit: Shutterstock photoBy Colin Lloyd :
Liquidity in financial markets means different things to different participants. A sharp increase in trading volume is no guarantee that liquidity will persist. Before buying (or selling) any financial instrument, the first thing one should ask is "how easy will it be to liquidate my exposure?" This question was at the heart of a recent paper by the UK Government: " The future of computer trading in financial markets - 2012 ." Here are some of the highlights:
The crux of the issue is whether market-makers have been replaced by traders. This trend is not new. On the LSE, the transition occurred at "Big Bang" in October 1986. The LSE was catching up with the US deregulation, which prompted the formation of NASDAQ in 1971.
Electronic trading, once permitted, soon eclipsed the open outcry of futures pits and traditional practices of stock exchange floors. Transactions became cheaper, audit trails, more accurate and error incidence declined. Commission rates fell, bid/offer spreads narrowed, volumes increased, in an, almost, entirely virtuous circle.
The final development, which was needed to insure liquidity, was the evolution of an efficient repurchase market for securities - sadly, this market place remains remarkably opaque. Nonetheless, the perceived need for designated market-makers, with an obligation to make a two-way price, has diminished. It has been replaced by proprietary trading firms, which forgo the privileges of the market-maker - principally lower fees or preferential access to supply - for the flexibility to abstain from providing liquidity at their own discretion.
In the late 1990s, I remember a conversation with a partner at NYSE Specialist - Foster, Marks & Natoli - he had joined the firm in 1953 and sold his business to Spear, Leeds Kellogg in 1994. He told me that during his career, he estimated the amount of capital relative to size of the trading portfolio had declined by a factor of five times.
Since the mid 1990s, stock market volumes have increased dramatically as the chart below shows:-
Source: NYSE.
The recommendations of the UK Government report include:
At no point do they suggest that all market participants - especially those with principal or spread risk - be required to increase their capital. This will always remain an option. An alternative solution, the reinstatement of designated market-makers with obligations and privileges, is also absent from the report - this may prove to be a mistake.
An example of technological emancipation
In this paper , "Review of Development Finance - The impact of technological improvements on developing financial markets: The case of the Johannesburg Stock Exchange - Q3 - 2013," the authors investigate how the adoption of the SETS trading platform transformed the volume traded on the JSE:
If market participants had been required to increase their capital in line with the increased volume, the transformation would have been far less dramatic. This is not to say that increased trading volume equates to increased risk. Technology has improved access, traders are able to liquidate positions more easily, most of the time, due to improved technology. At any point in the trading day, they may hold the same open position size, but by turning over their positions more frequently, they may be able to increase their return on capital (and risk) employed.
Federal Reserve concern
The Federal Reserve Bank of New York's Introduction to a series on Liquidity published eleven articles on different aspects of liquidity during the last three months; here are some of the highlights:
This seems to ignore the effect of QE on the "free-float" of T-Bonds. The chart below shows the growth of the Federal Reserve holdings during the last decade:
Source: St Louis Federal Reserve.
Unlike the FX and equity market, the US government still appoints primary dealers who have privileged access to the issuer. This probably explains much of the improved price continuity.
For many years, the T-Bond future was regarded as the most liquid market and was therefore the preferred means of liquidation in times of stress. The most extreme example I have witnessed was in the German bond market during re-unification (1988). The Bund future was the most liquid market in which to lay off risk. As a result, Bund futures traded more than 10 bps cheap to cash and cash Bunds offered a yield premium of 13bps to bank Schuldschein - unsecured promissory notes.
The introduction of electronic trading in T-Bond cash markets has created competing pools of liquidity which should be additive in times of stress. The increasing use of Central Counter Party (( CCP )) clearing has allowed new market participants to operate with a smaller capital base.
This evolution has also been sweeping through the Interest Rate Swap market, reducing pressure on the T-Bond futures market further still.
On the Frankfurt stock exchange, each Bund issue is "fixed" at around 13:00 daily. This process creates a liquidity concentration. A similar "clearing" process occurs at the end of LME rings. For spread traders, the ability to "lean" against a relatively un-volatile market - such as during a workup - whilst making an aggressive market in the correspondingly more volatile companion, represents an enhanced trading opportunity. One side of the potential spread price is provided "risk-free."
I refer back to my conversation with Mr. Foster, the NYSE Specialist; in asset markets - equities and to a lesser extent bonds - as volume increases during a bull market, the number of market participants increases. In this environment, "liquidity providers" trade more frequently with the same capital base. Subsequently, as volatility declines - provided trading volume is maintained - these liquidity providers increase their trading size in order to maintain the same return on capital. When the bear market arrives, the new participants, who arrived during the bull market, liquidate. The remaining "liquidity providers" - those that haven't exited the gene pool - are left passing the parcel among themselves as the return on capital declines precipitously (the chart, some way below, shows this evolution quite clearly).
Given the "quest for yield" and the reduction in T-Bond supply due to QE, this shift in market structure is unsurprising; however, the relatively illiquid nature of the Corporate bond repo market means much of the activity is based around "carry" returns. Participants are cognizant of the dangers of swift reversals of sentiment in carry trading.
The Fed methodology is contained in a four-page paper A Note on Measuring Illiquidity Jumps . It may be of interest to those with an interest in exotic option pricing. I'm not convinced that I agree with their conclusions about Liquidity Risk - it is difficult to measure that which is unseen.
Market liquidity in a given market is never constant, the trading volume may remain the same but the market participants, wholly different. In the 1980s, Japanese institutions were a significant influence on the US bond market; today, it is the Federal Reserve. Changes, such as minimum price increments and exchange trading hours are significant; the list of factors is long and ever changing. The increase in Liquidity Risk has as much to do with the increase in systematic trading and the relative consistency of approach these traders take to risk management. These traders and their methods have become increasingly prevalent. Whilst cognizant of skewness, they see the world through a Gaussian lens. They measure strategy success by the Sharpe and Sortino ratio, assessing it by the minute or the hour and being "flat" by market close.
Sources: Reuters, Haver Analytics.
The chart above looks at one minute reversals on the Dow. As long ago as 2003, the HFT customers I dealt with were operating on sub-second reversal time horizons. Nonetheless, the pattern of profitability may be broadly similar.
Since the Mutual Fund "Late Trading" scandal of 2003, arbitrage operators have maintained a low profile. The "flight-to-quality" properties of T-Bonds should also mean mass redemption is a much lower probability - "mass subscription" is a higher risk.
In the days of open-outcry trading on futures exchanges, "local" traders would frequently cancel and replace bids and offers. These participants were visible, their reliability, or otherwise, was known to the market place. In an electronic order book, there is less transparency. Algorithmic trading solutions have developed, over the last twenty years, to enable efficient execution in this more opaque environment.
"Cost plus" pricing for equity and futures execution is still quite rare outside the HFT world but it has had a dramatic influence on the stock market micro structure and liquidity since the 1990s.
In a recent speech by Minouche Shafik of the Bank of England - Dealing with change: Liquidity in evolving market structures - suggested that the changes in liquidity are a natural process:
The Deputy Governor goes on to remind us that the BoE acted as Market Maker of Last Resort during the last crisis and would do so again.
Conclusion - Financial markets - for the benefit of whom
Financial markets evolve to allow investors to provide capital in exchange for a financial reward. Technology has increased the speed and reliability of market access whilst reducing the cost; however, these benefits change the underlying structure of markets, be it co-location of servers in the last decade or block-chain technology in the next.
Politicians seek to encourage long-term investment; high frequency trading is a very short-term investment strategy indeed, but without short-term investors - shall we call them speculators - the ability to transfer capital is severely impaired. Even the most jaundiced politician will admit, speculators are a necessary evil.
Innovation has democratized financial markets, it has enabled individual investors to create complex portfolios and implement strategies which were once the preserve of hedge funds and investment banks; however, the experience has not been an unmitigated success. In the process, it purportedly enabled one man from Hounslow to wipe $750bln off the value of the US stock market in May 2010. That this was possible defies credulity for many; I believe it indicates how technology has more than offset the decline in capital allocated to financial market trading. Nonetheless, when it comes to financial market liquidity, I concur with Deputy Governor Shakif: caveat emptor .
See also Corporate Bond Market Stressed, But Not Yet In Crisis on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
