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The Liquidity Problem

Traders Magazine Online News, May 17, 2018

Jared Dillian

Individual investors generally don’t think about liquidity. You send a market order for 200 shares of something, it gets filled instantaneously, no problem.

Institutional investors have to think about liquidity a lot.

Say you have 200,000 shares of a stock to sell that only trades, on average, a million shares a day. You have a problem.

As a general rule, if you are more than 10% of the volume in a stock, you are going to have an impact on the price. You could spread the execution out over two days, but then you assume more price risk.

In ye olde days, you could call up the equities floor at a bank and do a block trade in the third market, and transfer your risk immediately. But that doesn’t really exist anymore. You are kind of stuck putting it in the machine, and you are kind of stuck having a bunch of computers sniff out your order and trade ahead of it.

The proponents of the computers say that they provide liquidity, which is partially true, and the detractors of the computers say they consume liquidity, which is also partially true. It is a complicated issue. Of course, there are all sorts of countermeasures and counter-countermeasures to this sort of thing, which has been the subject of a couple of books.

The problem is that there is a lot less liquidity out there than there was six months ago, and there is really a lot less liquidity than there was 10+ years ago. We will explain why.

Volatility and Interest Rates

When volatility goes up, liquidity generally goes down. As you know, volatility has been higher, so liquidity has been lower.

By the way, a good definition for liquidity is being able to transact at a price that is not disadvantageous—i.e., the price you see on the screen.

Perhaps some of you have access to a futures terminal and have seen the order book for S&P 500 e-mini futures. You have probably seen that it is often less than 100 contracts per tick.

If you go back to 2006, there were about 2,000 contracts per tick. Yes, liquidity is down over 90%.

So, individual investors generally don’t think about liquidity, but they probably should. At ETF 20/20, we prefer funds with a lot of liquidity, although that is not always possible. This month, we’re adding a fund with low liquidity, but the reasons for its low liquidity are valid.

Anyway, there is an axiom in markets: volatility and liquidity are inversely correlated. There is a second axiom in markets: as interest rates increase, volatility usually increases, too.

The Fed has been withdrawing liquidity by hiking interest rates and conducting quantitative tightening. It’s not a coincidence that volatility exploded and liquidity disappeared.

But there’s more to it than that.

Index Arbitrage

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