Are Markets Liquid Enough?

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Liquidity is no longer what it used to be. It's significantly down, at least since the beginning of 2018. One of the reasons — perhaps: market dualism. Crudely speaking, there is (1) a regulated but slow market where NBBO is supposed to rule and (2) an unregulated trading realm of alternative trading systems, which may exacerbate market fragmentation and chop up liquidity into unconnected flashes and slacks. 

Liquidity risk — the possibility markets will struggle to absorb selling demand without large price moves — has become a major concern.

Argues Bill Bain:

As the unwind continues, Financial Assets inflated by the free-money effects of QE are still finding new equilibrium valuations. Markets will remain volatile. Tech change and supply fundamentals will continue to shock us – look at oil prices for an example; turning a good year for oil and energy into a question market. Or look at how iPhone sales in India have fallen off a cliff as people buy cheaper phones that do the same – commoditisation! 

The thing that scares me most is liquidity – the lack of it.

While Brian Levine explains his nightmare scenario:

The data is wrong, everything trades at dislocated prices relative to the NBBO, and everyone—justifiably—widens their spreads. That happens almost every time there’s volatility, largely because message traffic increases dramatically. This is due to the fact that the opportunity set is greater and there’s no economic disincentive for sending messages to the market, so more electronic orders come in. This slows the system, widening spreads and generating price dislocations, which triggers even more orders and compounds the delays—a predicament that is only further exacerbated by the fragmentation of the equity markets. As this happens, stocks may trade outside of the NBBO briefly in millisecond or microsecond increments, constituting what I consider a genuine flash crash. All of this becomes a negative feedback loop that causes more volatility. 

Interestingly, if you define a flash crash by the percentage of executions that took place outside the NBBO, one of the largest ones occurred in 2008 after the first TARP bill failed, according to internal analysis we did a few years ago. And the market didn’t snap back, with the SPX closing down 10% on the day and on its lows. I think that may have been why there wasn’t talk of a “flash crash” afterward, but clearly the market structurally failed pretty badly that day, too. This suggests to me that, 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.

The source.