Well, we're back... and still banging on about a favourite theme: "LIQUIDITY... AND THE LAC

ref:- "Liquidity mirage makes it hard for investors to know the true price of anything" by Bilal Hafeez, Markets Insight, The Financial Times

Ah yes... LIQUIDITY. The term can have different interpretations, but when it comes to markets Mr Hafeez defines it as "the ability to buy or sell a security"... and that's as good a definition as any, we reckon. It's a hugely important factor for investors, and the fact that it can be extremely difficult to quantify exactly the effects of a lack of liquidity diminishes its significance, not one bit... in fact, it's unpredictability makes it all the more dangerous.

In a slightly stretched reference to Oscar Wilde's character Lord Dartington's observation " a cynic is a man who knows the price of everything and the value of nothing" (Lady Windemere's Fan), Mr Hafeez adapts the quote to point out that a cynic would say that it's

who know the price of everything and the value of nothing. A bit harsh probably, but it does allow him to then inform us that things may be much worse than that... they may not even know the price.

What can he mean by that? Surely it's one of the trading's absolute truths that the right price is what the market says it is? Well yes... the bankruptcy courts have been full of people who believed that the market price was the wrong price and that they knew the correct one. And guess what? Some of them have even been right. Their estimation of a security's true worth has been vindicated by the market's valuation falling into line... eventually. The trouble is, the market has moved so far against them in the meantime (or has taken so long to readjust its valuation) that those investors whose instincts might have been sound have long since been chewed up and spat out. A large part of investing may be about finding something to buy which may be considered too cheap (or for that matter something to sell that is too expensive), but when it comes to managing positions never forget that whatever you may think, it's ultimately the market that decides what they're worth.

And in normal conditions that's fine. But what if market moves are suddenly no longer influenced by such factors as economic performance and are more the result of a poorly functioning market?

Which of course brings us back to liquidity, or rather the lack of it. As it happens, by coincidence (?) there's a piece front and centre of the FT's Markets Section today about recent "flash crashes" in foreign exchange markets caused by lack of liquidity. But mostly those have been caused by the timing of events. Currency markets have always operated around the clock but obviously, sometimes (and time zones) are a lot more liquid than others. For example, you might be able to unload one mega-position after another when Europe and the US are open for business without much affecting the price. But just try placing a large order when books are switching across the Pacific, and Sydney and Auckland hold the reins. It's pretty simple: large orders in thin conditions mean exaggerated moves.

That's always been the case. But lack of liquidity and the chaotic market moves it engenders has become a huge danger across all markets even when the whole world's awake, not just when Aussie Joe is waiting for Tokyo to get going. Mr Hafeez puts it down to three leading factors :

Firstly, the stupendous growth of electronic trading, with robots replacing humans to provide an endless stream of prices. Securities are bought and sold at the click of a button -- which sounds good, right? -- and with smaller entities able to take price feeds from larger providers it looks like there's abundant liquidity. But it's an illusion... and what's more, when prices move beyond certain parameters computers driven by algorithms have a tendency to close down (unlike humans). So instead of providing liquidity just when it is most needed, electronic trading systems mean that liquidity is withdrawn.

Secondly, the much-reduced role of banks in the market-making process. Post-2008 crisis, regulations to curb excessive behaviour by traders and the safety of the banks themselves -- which of course are admirable goals in theory -- have meant that it is now just too expensive for banks to provide the vital liquidity they once did. In the absence of their market-making function, price moves at times of stress are inevitably exaggerated. What's more, banks are often forced to sell securities into thin markets when previously they could have kept them on their book overnight. Net result ?... even more exaggerated moves.

Thirdly, it's the old Quantitative Easing thing. QE, central bank buying of securities as a form of easing monetary policy, has induced investors to think that there's always a buyer of last resort -- the so-called "Central Bank Put (Option) ". In other words, investors are of the belief that things will be a lot easier to sell in a hurry than will actually be the case -- remember, in most cases, QE has been turned off or is even being reversed.

So... liquidity-wise, we have a situation where things look just dandy if conditions are "normal": streams (and streams) of prices, no need to speak to human market-makers, the likelihood of central bank intervention (in some form). It's when things go pear-shaped that we're going to see liquidity disappear : No streaming prices as the robots close down, their human equivalents constrained by regulation, and central banks either too slow to turn the tide (assuming they were of a mind to do so) or indeed changing the direction of policy altogether.

The point is this: the danger is that investors are UNDERPRICING their liquidity risk, and therefore in effect overvaluing their assets. The screens tell them that investment ABC is worth X, but it might be worth an awful lot less if they're forced to sell when the market's in turmoil. Sharp market moves may well be determined less by economic fundamentals and more by a repricing of the liquidity risk. Could be nasty... and, doves would argue, something central banks might want to consider as they go about unwinding easing policies at a time when the future looks a bit uncertain.

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