Scarce Liquidity Is a Growing Risk

(Bloomberg Opinion) -- No one can predict how bad the next financial crisis will be. What’s certain, though, is that a lack of liquidity will make the fallout much worse.

Holders of securities, currencies and commodities need trading liquidity so they can adjust positions, raise cash to meet redemptions, reduce their risk, or limit losses. Yet they seem to anticipate more liquidity than there actually is. Outside of a few stocks, major currencies and some government securities that trade consistently in large volumes, few instruments are truly liquid. High trading volumes and low bid-offer spreads are misleading. Earlier this month, as political chaos gripped Italy, volumes shrank and the bid-offer spread tripled with alarming speed.

Several factors could lead to a dangerous shortage of liquidity in the event of a crisis. First, since 2009, low interest rates have driven investors into riskier, less liquid assets in search of return. These include longer-dated securities, corporate bonds and emerging-market issues -- frequently of low credit quality -- as well as mid-cap shares or investments in smaller and often less-developed equity markets.

The risks posed by such investments frequently seem underappreciated. Too many investors are buying assets on the assumption that they’ll be able to sell out quickly to a “greater fool,” before prices drop.

Second, concentration is high, with large funds, exchange-traded funds and specialized investors, such as high-frequency traders, dominating investments. About 50 percent of equity trading is directly or indirectly driven by ETFs, which are in turn managed by a few asset managers such as BlackRock Inc., State Street Corp. and Vanguard Group. Algorithmic traders and quantitative investors exhibit herding behavior, following near-identical strategies and holding similar portfolios. 

Third, investment vehicles are too often promising investors greater liquidity than their actual holdings can offer. Investors have the ability to redeem their money at relatively short notice, less than the time needed to liquidate their investments. A study by the International Monetary Fund found that a fund investing in U.S. high-yield corporate bonds might take up to 60 days to liquidate holdings.

Fourth, new regulatory measures such as higher capital levels and trading constraints are limiting the capacity of dealers to make markets. In the U.S. Treasury bond market, major dealer market-making capacity has fallen by about a third from 2007 levels -- around $2.5 trillion to $3 trillion -- even as the underlying markets have grown rapidly. The fact that so many financial institutions have consolidated and are now focusing on core markets and fewer clients hasn't helped.

Finally, investors are relying more on anonymous electronic platforms dominated by automated trading. These are users rather than providers of liquidity. Their activity creates the illusion of active trading when markets are rising or stable but absorb liquidity when prices fall or are volatile.

In a future crisis, a lack of liquidity will accelerate the effect of shocks and volatility. If enough participants or large holders look to exit their positions simultaneously, the limits on trading will exacerbate problems. Price movements will become exaggerated, increasing losses and driving volatility higher. This will set off a chain reaction via risk models, which will force ever more dramatic adjustments to portfolios and thus increase the demands on liquidity and price pressures. Trading costs will rise, leading to higher financing costs and lower returns.

Investors who are unable to liquidate positions will be forced to sell their better-performing or more liquid assets, leaving them stuck with lower quality, risky and less liquid positions. Funds might employ "gates," delaying or suspending redemptions. In 2007, the gating of some funds caused investor panic, spreading the problems and increasing selling pressures across markets.

Financial markets will be unable to absorb the stress. Dealers may be unable or unwilling to purchase cheap assets and warehouse them, exaggerating price fluctuations. If the shocks are large, markets could become disorderly or cease to function, making it impossible to exit at all.

Central banks may have to step in as buyers of first and last resort to prevent such volatility. This will entail a new commitment of taxpayer funds to support the financial system. If, as is likely, that support isn't withdrawn promptly, it'll perpetuate a never-ending cycle, distorting the normal functioning of markets and increasing risk.

One can see why investors are sanguine about the current situation. Declines in liquidity only become obvious in periods of sharp retrenchment, when buyers are looking to sell assets. If they don't start preparing now, though, those investors are going to be dangerously exposed in the next crisis.

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

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