“Liquidity Is The Novel Leverage”

From 13D Research, May 26:

Why the toxic combination of banking concern regulation, algorithmic investing, in addition to QT has lay equity in addition to bond markets at increased take away a opportunity of a systemic event.

The higher upward quote comparison liquidity to leverage comes from Goldman Sachs’ caput of Global Credit Strategy, Charles Himmelberg. Historically, leverage “is the tinder that turns a fiscal burn into an inferno,” as The Financial Times put it recently. However, since February’s flash crash, Himmelberg has in 1 trial to a greater extent than in addition to in 1 trial to a greater extent than sounded the alert that the algorithmic transformation of markets way liquidity, non leverage, should endure the preeminent, catalytic work concern every bit quantitative tightening progresses in addition to volatility returns. “I routinely champaign questions from clients scream for where the risks are edifice up, in addition to this is the 1 I worry about,” he told The FT earlier this month. “Financial markets accept changed pretty dramatically since the crisis.”

In these pages, we accept sought to sympathise the implications of the algorithmic in addition to passive revolution, 1 of the most profound changes to the global fiscal arrangement inward history. And nosotros choke on coming dorsum to liquidity every bit the commutation threat — if a marketplace stupor causes algorithmic strategies to simultaneously unwind or the passive herd to flee, furnish could speedily overwhelm demand, causing widespread panic. Now, mounting testify suggests the threat is intensifying. Speaking to The Wall Street Journal, Jeffrey Cleveland, primary economist at Payden & Rygel, lay electrical flow marketplace liquidity inward stark terms: “It’s similar going into a grocery shop in addition to there’s cipher on the shelves.”

Whether inflation, involvement rates, margin line per unit of measurement area or a domestic or global political crisis, it is non even in addition to therefore clear when a marketplace stupor volition come upward in addition to what volition endure the catalyst. However, the to a greater extent than threats mount, the to a greater extent than essential it becomes to sympathise how an ever-illiquid marketplace mightiness react nether stress. Based on all available evidence, hurting volition come upward far faster in addition to alongside far greater severity than most anticipate.

Post-crisis banking concern rule is at the middle of the liquidity problem. As The FT documented recently:

“Since the fiscal crisis, regulatory changes accept aimed to purge leverage from the system, primarily yesteryear severely curtailing the purpose that banks accept traditionally played inward providing liquidity…Instead of relying on residuum sheets to lubricate trading, banks accept larn to a greater extent than similar brokers in addition to embraced the algorithmic techniques of high-frequency traders…On the whole this has made markets to a greater extent than efficient, alongside the departure betwixt the cost investors accept to pay or volition have for a fiscal asset — the “bid-ask spread” — narrowing to tape lows. By this mensurate fifty-fifty the bond marketplace today looks to a greater extent than “liquid”. But some analysts in addition to investors said markets that may seem superficially to a greater extent than efficient were to a greater extent than prone to “liquidity crises”, where waves of sellers of a precipitous overwhelmed the depleted capacity of market-makers such every bit banks to absorb in addition to intermediate the purchase in addition to sell orders.”

According to Mauldin Economics, Dodd-Frank requirements accept reduced major banking concern market-making abilities yesteryear every bit much every bit 90%. In to a greater extent than anecdotal terms, Goldman Sachs’ president David Solomon told The FT that the banking concern used to accept 500 people dedicated to making markets inward equities in addition to at in 1 trial has exclusively three. A similar dynamic is apparent inward the bond market. In a newspaper released inward October, “Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs”, the Federal Reserve Board concluded: “Among trades where customers are demanding liquidity” — where dealers aren’t but matching customers, but truly providing immediacy themselves — “we abide by that these customers pay 35% to 50% higher spreads than before the crisis.”...

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