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Markets Should Be Worried About the Music Stopping

Satyajit Das

(Bloomberg Opinion) -- Several factors are roiling world markets right now, from fears of a possible U.S. recession to erratic policymaking, trade tensions and general uncertainty. But the unusual size of the moves -- regularly on the order of 1% to 3% -- is being heightened by something else: the struggle to find someone with whom to trade.

The decline in trading liquidity is evident in several metrics. Volumes have declined. Since 2007, average daily trading in U.S. Treasury bonds (measured as a percentage of market size) has fallen by over 60%. Trading in traditionally less liquid corporate and high-yield bonds has shrunk by similar amounts. The number of small trades (under $1 million) has grown, suggesting a lack of partners for larger deals.

Over the same period, U.S. equity market turnover has also shrunk. The Goldman Sachs Group Inc. estimates that in 2018, by some measures, single-stock liquidity fell 30% to 40%. Other telling indications include significant intra-day moves, frequent price spikes, higher volatility of bid-offer spreads and the proliferation of flash crashes such as the sharp increase in the Cboe Volatility Index or VIX at the end of 2018 and the Japanese yen flash in January 2019.

Structural changes are driving this trend. For a variety of reasons, traditional market-makers such as banks and dealers have become less active; bank trading assets have fallen from 40% of total assets in 2008 to half that figure. Regulatory changes have made trading more capital-intensive. Meanwhile, industry consolidation has reduced the number of participants. The trading inventory of government and especially corporate debt has fallen.

Trading liquidity has instead become dependent on different kinds of investors. Algorithmic traders now make up around 50% of U.S. equity trading. Other providers range from pension fund and insurance companies to mutual funds, exchange-traded funds or ETFs, hedge funds and private investors.

This increased role for investors may be problematic. Investment funds and algorithmic traders are not natural providers of liquidity. They channel investor money. Unlike banks, they do not have permanent capital to risk in providing liquidity or warehousing positions.

Traditional market makers, such as banks, can buy or sell based on assessed true value, building inventory and waiting for market fluctuations to subside. In part, this is made possible by the greater stability of their funding and capital base.

By contrast, funds are limited in their ability to make markets by adjusting prices. Their ability to buy and sell is dependent on the flows of investible funds. Large inflows necessitate buying, as most fund have limits on how much money they can keep in cash. At the same time, since most funds offer investors the chance to withdraw their money on short notice, redemptions obligate funds to sell.

Where investors are leveraged, the need to meet margin calls restricts liquidity and trading activity. This further limits the ability of investors to provide market liquidity just when it’s most needed.

Other investors are constrained by mandates and investment rules. ETFs, which are now a major influence, must adjust holdings to reflect the underlying benchmark, irrespective of value or price considerations. Algorithmic traders compete with central and commercial banks in chasing safe and highly liquid assets. Perversely, this diminishes liquidity for those assets.

Diminished trading liquidity has several implications for investors. Their ability to trade is increasing fragile. Volumes can evaporate quickly when volatility rises, as investors turn from buyers to sellers and algorithmic traders withdraw. In effect, providers of liquidity then become users, destabilizing markets. Price discovery, which underlies all trading and valuations, becomes unreliable.

The different focus of investors in the current cycle complicates matters. Investors searching for return have invested in riskier, less liquid assets. As investors in Argentina have discovered, a quick exit is sometimes impossible in emerging markets.

There’s also heightened risk of investors being unable to exit “gated” funds where redemptions are suspended. The three largest U.K. property funds froze over $12 billion in assets in the aftermath of the Brexit vote. More recently, the Swiss fund manager GAM Holding AG and iconic U.K. investor Neil Woodford have blocked redemptions. Bank of England Governor Mark Carney has warned that investment funds that promise to allow customers to withdraw their money on a daily basis are "built on a lie."

There are broader implications. Illiquidity may precipitate fire sales and large asset price moves, resulting in sudden and sharp tightening in financial conditions.

In 2007, then-Citigroup Inc. head Chuck Prince made an ill-fated comparison to investing as a game of musical chairs: You kept dancing while the music played. The problem, as traders are rediscovering, is finding a chair when the music stops. Investors are underestimating and under-pricing the risks diminished market liquidity could pose in the next downturn.

(Corrects to delete reference to H2O Asset Management LLP as a “gated” fund in thirteenth paragraph. )

To contact the author of this story: Satyajit Das at sdassydney@gmail.com

To contact the editor responsible for this story: Nisid Hajari at nhajari@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Satyajit Das is a former banker and the author, most recently, of "A Banquet of Consequences."

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