04 February 2016
The Liquidity Illusion
What happens if everyone wants out?
by Frank O’Nomics
On 24th August last year the Dow Jones index of US stocks experienced a so-called “flash-crash”, dropping around 1,100 points (roughly 7%) in the first five minutes of trading. There are lots of theories as to what caused it, but perhaps the most reason most often for so extreme a move is a lack of liquidity – traders were just not prepared to buy everything that people wanted to sell. Similarly, we have had a number of occasions this year when the Chinese market has fallen sufficiently (again around 7%) to prompt a halt in trading and a significant knock-on effect on the trading of developed markets. All of this has led many to question the ease with which one can get out of investments when markets turn. There are concerns that many funds are being marked as if they were highly liquid, but may ultimately be anything but – corporate bond ETFs spring to mind as a potential example. What appears to be liquid now may be illiquid very quickly – the Shanghai stock market was the most liquid market in the world (measured by volumes traded) just three weeks before the crash in January.
This poses the question of just how exposed we (or our investment managers) should be to any particular asset or indeed a single stock within an asset class. What risks should we factor in to incorporate the dangers of being a forced seller? It has also posed questions for regulators. In a period of uncertainty how can they ensure that the private sector generates sufficient liquidity for the efficient operation of capital markets?
That this is a major concern for the authorities is illustrated by the number of recently sponsored studies. Liberty Street Economics, the blog site of the New York Fed, has published two analyses of liquidity in US Treasuries, corporate bonds and other markets, while the Bank of England has published “The resilience of financial market liquidity”. The financial industry itself has taken steps to examine the situation, with the Global Financial Markets Association and the Institute for International Finance commissioning PWC’s Global financial markets liquidity study.
Standard investment management theory suggests that, from a personal portfolio approach, we should all keep a proportion of our funds in cash so that we can cope with a change in our circumstances, or take opportunities when they arise. Typically, depending on the size of our portfolios, this will be 5-10% of our fund. Similarly, most investment funds have to retain a portion of their funds in cash to cater for clients who wish to sell (called a liquidity buffer), and the size of this will be highly dependent on the underlying liquidity of the other assets in the fund. If we are looking at a property fund, clearly it is difficult to sell any assets quickly, so a reasonable cash balance needs to be held to address any withdrawals. On the other hand, funds invested in more freely quoted equities with a reasonable capitalization will not need to hold much cash as they can readily sell stock at a moment’s notice to cater for redemptions.
For all of these funds any holdings of cash are a potential opportunity cost as they constrain the fund’s ability to take the full benefit of the target asset’s performance. The problem for the fund managers is that market liquidity is not a constant factor and will vary over time. Perhaps the bigger issue for them is that liquidity has a cost. The price of owning highly liquid assets, such as developed market government bonds, will typically rise during times of great uncertainty. It is clear that we are currently in the midst of such a time, with over 25% of core-European government bond markets now generating negative yields (ie you have to pay the governments to lend them money).
For those managers of assets less liquid than government bonds, there is an ongoing need to assess market liquidity and to factor this in to how they manage fund redemptions over time. In volatile periods funds will obviously have to increase their liquidity buffers, and this is likely to have an impact on fund performance. With more volatile assets it may be that they have to invoke notice periods that investors have to give before they can realize their money, or could involve penalties for early or sizeable redemptions. In extreme cases it could also mean that funds cease to trade for periods of difficult liquidity, making it impossible for investors to get at their money for a period of time. The calculation, and stress tests, that funds have to go through are complicated and ever evolving, but it seems likely that, if the current levels of volatility are to persist, we will get a stream of correspondence from investment managers telling us of rule changes within their funds. This is the sort of correspondence that most of us ignore, but we would be well advised to start to pay more attention.
For the regulators there is the difficulty of balancing the need to ensure that, when the private sector is failing, the authorities step in to satisfy the public need. This, however, needs to be a careful balance, as over regulation, such as insisting that banks pare back balance sheets to conform with extreme stress tests, can help to undermine rather than promote liquidity. Having “circuit breakers” that suspend market trading for certain periods, or preventing the “shorting” of stocks during periods of extreme market weakness have proved effective in the past but need to be used selectively to ensure that markets remain efficient.
To a large extent it does seem that markets are operating efficiently, with short-term extreme volatility quickly dissipating. It is notable that, as a result of low US corporate bond yields, dealer inventories have fallen substantially, having been in excess of $240 billion prior to the Lehman’s failure in 2008, to around $50 billion, while turnover has risen to levels above that of 2007. This suggests that the market is being effective in matching buyers and sellers, helped to a large extent by improvements in technology (much trade takes place on electronic platforms). However, this data will do little to stop the headline writers generating concern each time we have a sharp sell-off in markets and investors will need to be careful as to how they allocate their cash. We are likely to face a difficult transition period as we (eventually) move to a post-QE era, which should at least lead to a widening of bid-offer spreads and hence execution costs for many assets. The short answer to this conundrum is, don’t assume that you will be able to sell whenever you want.
