The Liquidity Delusion

The following is an excellent excerpt from the book “THE ONLY GAME IN TOWN: Central Banks, Instability, and Avoiding the Next Collapse” by Mohamed A. El-Erian from Part III: “From the What to the So What” from Chapter 16: “The Liquidity Delusion” on page 114 and I quote:

“Unlike other bond markets, U.S. Treasuries are viewed as being open for business for the entire global trading day. . . . Any indications that the market can suddenly shut down with little warning raises troubling questions about how the nature of trading has changed in recent years.”                                         –TRACY ALLOWAY AND MICHAEL MACKENZIE

“The impact of liquidity of ETFs, liquid alternatives and the Volcker Rule are yet to be tested in tough times.  We’ll see what happens in the next serious downturn.”         –HOWARD MARKS

“Issue 8: When the market paradigm changes, as it inevitably will, the desire to reposition portfolios will far exceed what the system can accommodate in an orderly fashion.

In one of the scenes in When Harry Met Sally, the 1989 comedy starring Billy Crystal and Meg Ryan, Sally talks to Harry about her relationship with Joe.  She reminisces about how, as a couple, they prided themselves on the possibility of doing things at a “moment’s notice,” from flying to Rome to engaging in a certain act together on the kitchen floor.  But when Harry digs a little deeper, it turns out that the couple didn’t do any of these things.  It was more about thinking that they could do so, rather than actually doing it.

Judging from the portfolio risks accumulated in recent years–including the large amount of dollars at risk, the low compensation paid to investors for assuming such risk, and the extent to which many crowded portfolio positions can move together–investors appear to strongly believe that the markets would provide ample liquidity for them to reposition their portfolios should they ever need to.  That is to say, when the time comes to sell or buy securities, there will be someone on the other side willing to transact in size and at a reasonable cost.  Yet there are many reasons why this is unlikely to be the case, setting up the markets as a whole for some harrowing roller-coaster journeys.

Interestingly, this expectation of ample liquidity runs counter to what has actually transpired when consensus views have changed and investors have sought to reposition their portfolios accordingly.  In May-June 2013, when Chairman Bernanke uttered that famous word–“taper”–and raised questions about the Fed’s continuous support for markets, many investors were unable to complete their desired transactions for even the most vanilla-type securities.  The same thing occurred again in May-June 2015, this time in the usually staid markets for German government bonds.  Again prices moved violently on very little volume, with many investors feeling frustrated by their inability to reposition their portfolios fully and in a relatively cost-effective manner.

These are but two of many examples of episodes in the last couple of years in which broker-dealers have shown very little appetite to take on the risks that end investors were looking to dispose of.  In each of these episodes, the resulting large gapping in market prices was accompanied by rather illiquid markets, and in a manner that worried the Federal Reserve and other regulators charged with overseeing the smooth functioning of markets–and rightly so.

On several occasions, I have argued that liquidity is the most underappreciated risk factor for investors today.  The potential problem is a change in markets’ conventional wisdom that induces a collective desire to reposition portfolios into illiquid markets.  The result is a series of cascading disruptions as investors, unable to dispose of certain assets, look to liquidate other holdings to compensate.  As prices overshoot and correlations spike, various tipping points are triggered, forcing the capitulation of overleveraged broker-dealers and investors.

Concerns about liquidity have also been expressed by those close to the day-to-day functioning of the markets.  In his annual letter to shareholders in 2015, Jamie Dimon, chairman and CEO of JPMorgan Chase, noted that “already. . . there is far less liquidity in the general marketplace.”  This becomes a bigger issue “in a stressed time because investors need to sell quickly and, without liquidity, prices can gap, fear can grow and illiquidity can quickly spread–even in the most liquid markets.”

Liquidity was also rated as the number one concern by David Hunt, the CEO of Prudential Investment Management.  In calling it a “big risk,” he added that “it is one of the unintended consequences” of recent regulatory changes.

The risks associated with the widespread illusion of ample market liquidity–actually, it is more accurate to call it a delusion–speak to more than the threat of sharp price movements and strains to the functioning of markets.  Periodic episodes of liquidity-driven dislocations can cause longer-term market damage that undermines economic activity–a similar dynamic to when a sovereign’s severe liquidity crisis risks turning into a solvency one.  Using economic jargon for those of you that are so inclined, it illustrates the extent to which the velocity-adjusted quantity of “money” has been endogenized by markets, rendering central bank policy effectiveness even more vulnerable to swings in market risk appetite.

As noted earlier, there have already been quite a few liquidity frights within the overall liquidity fest led by central banks looking to suppress financial market volatility.  It is what the insightful economist Nouriel Roubini has called the “liquidity paradox.”  These periods of liquidity stress were chilling enough to force central banks to intervene even more, illustrating once again that these powerful institutions didn’t have much appetite for pronounced financial volatility.  They felt compelled to rush out reassuring statements of support for the markets and, in some cases, to follow up with actions.  As a result, the dislocations ended up being blips rather than catalysts for a series of further disruptions and mayhem.

After spiking, the VIX, or CBOE Volatility Index, which is commonly referred to as the markets’ “fear gauge,” returned rapidly to its unusually low level (Figure 9)–leading someone I greatly respect to take to Twitter to wonder whether the index should be renamed the “complacency” or “hubris” index.

The faster markets recovered in response to additional central bank interventions, the greater the conditioning for investors to brush aside liquidity concerns and take on even more risk at inadequate historical compensation for doing so.  This would not be as much of a concern to global economic and financial stability if it weren’t for some consequential structural changes.

The last few years have seen a fundamental change in the structure of market intermediation, that is, the setup under which markets move inventories among different participants.  Most notably, the size of the market makers and their appetite for assuming balance sheet risk have shrunk considerably relative to the universe of clients they serve (Figure 10).

Pressured both by regulators looking to de-risk finance in order to avoid another 2008 global financial crisis, and by shareholders who have diminished appetite for countercyclical adventures, dealers have been a lot less willing to take the other side of large trades.  As such, the intermediation capacity that sits at the core of the established market system and lubricates its functioning has been materially shrunk.  Not so for those that access it.  The last few years have seen a meaningful growth in the size and complexity of end users, be they asset managers, hedge funds, pensions, insurance companies, or sovereign wealth funds.  Yet, having to go through a diminished middle, the pipes that link them have done more than fail to keep up in relative terms; they have actually contracted.

Two factors amplify the consequences of this growing imbalance, which is particularly acute for certain asset classes that lack inherent depth (such as emerging corporates and high-yield bonds) as well as products that many investors seem to believe are always highly liquid at acceptable prices (from ETF structures to TIPs).

First, only the middle circle has access to funding windows of central banks.  The end users in the outer circles do not.  As such, there is no easy way to diffuse the pressure of too much flow trying to get through very narrow intermediation pipes.

Second, while there have been attempts to relieve the pressure by building new pipes that connect the end users directly–including that spearheaded by BlackRock, the world’s largest asset manager–the outcome has been disappointing. It appears to be operationally difficult and legally challenging for end users to deal with one another directly and largely bypass the broker-dealers.  Moreover, as much as these end users (known in the industry as the “buy side”) distrust the broker-dealers (the “sell side”), they often worry even more about divulging information to one another given the intense competition between these asset managers.

Stand-alone exchanges have relieved some of the pressure but not enough.  Accordingly, the current structure has too few release valves to cope with attempts to transact in size and quickly.  In fact, if anything, broker-dealers are likely to act pro-cyclically–that is, join the buy-side herd–rather than use their balance sheets in a countercyclical manner.  This is particularly the case for those that are wedded to VAR-type approaches for managing their balance sheet risks, under which an increase in market illiquidity and volatility increases measured risk, forcing a comensurate deleveraging.

All this speaks to what I believe is a systemic–and potentially dangerous–underestimation of the liquidity risk facing the global financial system, one that is hard to deal with easily, given its structural underpinnings.”

(THE FOLLOWING IS FROM OLIVIER BLANCHARD ABOUT THIS BOOK AND FROM THE INSIDE JACKET COVER AND I QUOTE:

“From the rise of Airbnb and disruptive technologies to worries about Russian foreign policy and turmoil in the Middle East to negative interest rates and ‘the new mediocre,’ the world is an increasingly confusing place.  The job of policymakers is mind-bogglingly hard.  Who better than Mohamed El-Erian, with his knowledge of markets, his knowledge of policy, and his brilliant mind, to help organize their (and our) thoughts.  The Only Game in Town is a great read.”        –OLIVIER BLANCHARD, senior fellow at the Peterson Institute for International Economics

“Our current economic path is coming to an end.  The signposts are all around us: sluggish growth, rising inequality, stubbornly high pockets of unemployment, and jittery financial markets, to name a few.  Soon we will reach a fork in the road: One path leads to renewed growth, prosperity, and financial stability, the other to recession and market disorder.  Now Dr. Mohamed A. El-Erian, one of the world’s most influential economic thinkers and the New York Times and Wall Street Journal bestselling author of When Markets Collide, has written a roadmap to what lies ahead and the decisions we must make now to stave off the next global economic and financial crisis.”

MY COMMENTS: THE UNREGULATED, TOXIC DERIVATIVE MARKET WAS MADE POSSIBLE BY THE BIG INVESTMENT BANKS USING OFF-BALANCE-SHEET ACCOUNTING WHICH MEANS THEY WERE USING TWO SETS OF BOOKS. DUE OT THE FACT OF THERE WERE NO REGULATIONS ON THEM, THAT’S WHERE THEY WERE PUTTING ALL THEIR BAD LOANS TO MAKE THEIR FIRST SET OF BOOKS LOOK PRESENTABLE.  I HOPE SEN BERNIE SANDERS BRINGS THIS OUT IN THE DEMOCRATIC CONVENTION.

LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran

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About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog (my.barackobama.com) and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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