Increasingly more trading professionals are becoming worried about some "terminal" event in market liquidity, one which sees stocks breaking lower and failing to snap back.
One week ago, we quoted Goldman's co-head of trading, Brian Levine, the man responsible not for some weekly research periodical but running arguably the most sophisticated trading floor in the world, said that his biggest concern is that the market may "break" and not snap back:
... 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.
Now, the head of Global FX Strategy at Nomura, Bilal Hafeez, picks up where Goldman left off and in a note titled "the market risk no one is talking about, but should have everyone worried", confirms that the biggest threat facing the market is the market itself.
Hafeez first notes the growing frequency of market quake events, noting that this year has seen numerous bouts of risk aversion from the VIX spike in late January to the Italian bond sell-off to the ongoing EM sell-off. As the Nomura strategist explains, "by their nature, these were unexpected, but they also delivered two larger surprises. First, the lack of correlation between markets. Normally, we would expect contagion and a more cathartic sell-off across multiple markets. This could simply be a case of tremors before the “earthquake” where correlation will return."
But it is the hidden risk of poor market liquidity that is the cause of sleepless nights:
The second and less discussed surprise has been the dire state of market liquidity during these risk aversion episodes. Investors attempting to unwind their positions have struggled to do so. Unable to find bids in the market, they have either had to keep those positions or exit other more liquid investments.
Hafeez then points out another risk we have discussed in recent months: the growing fragility of the market itself, a topic which Goldman's Chief Markets Economist Charles Himmelburg has been obsessing about recently as well:
This was not supposed to happen. Markets were supposed to be more liquid thanks to ample central bank accommodation and the electronification of financial markets. But it may well be these forces that have resulted in the fragility of market liquidity.
What changed? Stated simply, it is the structure of the market itself - one now dominated by selective liquidity providing HFTs and algos, eminently confident a selloff will never be permitted by central banks - that has mutated to such a degree that it is becoming increasingly impossible to have a normal selloff without the market itself breaking.
A number of forces have affected the microstructure of markets since the financial crisis of 2008. There has been the dramatic growth of electronic trading platforms across most markets, the presence of central quantitative easing, the regulatory curbs on banks from warehousing risk and the sharp rise in passive investment funds.
Taken together, Hafeez caims that these factors influencing the microstructure of markets have given the illusion of liquidity in “normal” times, "but they all act against market liquidity during “volatile” times."
The algorithms behind trading platforms tend to withdraw bids in volatile times, QE has forced investors into the same positions, so all flow is one-way, banks have to match orders and so act more like brokers rather than a lubricant to market transactions and passive funds offer daily or intra-day liquidity for investors, but the underlying assets are often not that liquid.
Two last points from the FX strategist: what does this mean for the market, and how to trade it. Not surprisingly, in his take on the first issue Hafeez expects much more vol, more flash crashes, and greater gap moves, or the things which we predicted back in 2009 would eventually come to dominate a market that is controlled by central banks on the macro side, and HFTs on the micro:
The upshot is that we are likely to see more flash crash-type market moves, more gap moves and an increasing premium attached to more liquid markets. Already, we are seeing the frequency of multiple standard market moves increasing.
So how should one trade this increasingly broken market: according to Nomura, the best trade one can make now is to transfer from illiquid to liquid markets, and from physical securities to derivatives:
What is the antidote to this? The most obvious would be to stick to more liquid markets such as G3 FX and rates, but a more sophisticated approach would be to own options. By doing so, you are long market liquidity as you have the right to transact a given size at a given price. Therefore, we have a preference for liquid markets and introducing optionality into portfolios.
Here the obvious counter is that if the market breaks and is shut down, options will also be halted, with the added threat that theta could collapse during the "halted" period, resulting in a worthless security at expiration, unless of course it is deeply in the money and can somehow be converted for the underlying asset.