By Ian Domowitz, ITG
Much of the examination of equity markets today centers on how to cope with volatility. Investors want to know how the volatility of this year compares with that of cycles past or with low points in the market last year.
One common refrain we hear on the equity side is that there is a liquidity crisis and that there is not a clear path back to more robust liquidity conditions. I respectfully disagree.
I dont believe what we are seeing is a crisis of absent liquidity. There are certainly challenges to execution and accessing liquidity has become more difficult. There is no doubt that execution is more challenging during volatile times and that the cost of doing trades is on the rise when there are not easily discernable exit paths.
Liquidity has not dried up, but rather it has gotten more expensive. The cost of liquidity has moved up and thats made life difficult for people trying to be nimble in the markets.
We see that the cost of liquidity rises most sharply when we are surprised by shifts in the marketplace and when it settles back down, it may settle down to higher levels to accommodate those higher volatility levels. The cost of liquidity does not generally go back to where it was before the large push in volatility. This is because the cost of liquidity remains higher given the relative risk level.
This should not be surprising, but what is surprising is how much this difference in cost is considered a lack of liquidity. To cite a simple example, if you had a stock whose fundamental value was a solid $20 per share, you might, in trying to sell that stock, find that you dont have buyers. If you drop that price to $18 per share, people will come out of the woodwork to buy it. Its not that there was no liquidity in the market; there was no liquidity in the market at $20 per share; at $18 per share there could be quite a lot of liquidity.
When we crunched the numbers, we found that, globally speaking, the average cost of trading has been stable since 2013. What has changed more recently has been certainty of outcome. That trend has been steadily growing for the last several quarters.
So volatility is up, the certainty of outcome is down. What that says to me is that in terms of trader behavior we might want to think about probabilities as opposed to thinking about the averages. The fact that the certainty of outcome is dropping means that for whatever reason the strategies that are being used are working a little more like throwing darts at a wall. In other words, youre getting good outcomes and bad outcomes, but youre not in a good zone from a predictability standpoint. Id prefer to be in a zone where there were 50 basis points from the bottom 10% to the upper 90%, operate within that safer middle, and get my trading to successfully execute within that band.
The difference in the market today is most immediately characterized by this decline in the certainty of outcome. The cost of liquidity is behaving the same as we would expect during times that the market gets a surprise versus times when things are a little more stabilized.
Lets adjust our sights and move forward. This difficulty in finding liquidity doesnt mean its not there; it means we need to go back to the drawing board and come up with a strategy that will help us find it.
As with all times of stress, the difficulty in accessing liquidity provides us with a real opportunity to recalibrate our trading systems and strategies. Unpleasant surprises in the market can pay dividends in the future if we see them as strategy adjustment opportunities today.
Ian Domowitz is Managing Director at ITG
