By David Silverman
This material is copyrighted to the author, David Silverman, and may not be reproduced without the express written approval of Mr. Silverman.
As we commemorate the twentieth anniversary of the 1987 market crash, the eighteenth anniversay of the 1989 market crash, the fifteenth anniversary of the collapse of the European Monetary Market, the thirteenth anniversary of the Latin American debt crisis, the twelfth anniversary of the Barings downfall, the tenth anniversary of the market meltdown in the Pacific Rim, the ninth anniversary of the Long Term Capital Management debacle, the seventh anniversary of the dot.com bubble bursting, the sixth anniversary of 9/11, and, as I write these words, the ongoing subprime lending market crisis, it is worthwhile to consider the significance of liquidity. It is also important to recognize, as this list of ignominious events implies, that the market seems to be in a perpetual state of boom or bust. Consider the following quote from Business Week: “For 5 years at least, American business has been in the grip of an apocalyptic holy-rolling exaltation over the unparalleled prosperity of the ‘new era’ upon which we have entered.” As timely as these words might sound, they were written in 1929.
Really smart economists, some specializing in mathematical modeling and others in behavioral finance, have made progress in understanding what drives volatility and why individuals behave the way they do, and there’s a Nobel Prize waiting for the egghead who finds an antidote for the boom/bust cycle. But this would require cracking the market’s genetic code, mapping every potential combination of events, responses, and outcomes and figuring out what it all means. Not very likely, although I suppose if a trillion monkeys typed for trillion years they’d eventually produce a self-help book called “How to Avoid the Coming Crash”. This is not to say that we shouldn’t be studying the effects of crashes or thinking about ways to avoid being caught in the maelstrom. But you can only evade the effects of a cataclysm for so long. No matter how good your market timing, or how well hedged you might think you are, without a liquid market to shed your risk, you are no better off than an economist in the classroom or a monkey at a keyboard.
In practical terms, liquidity is best understood as: the ability to buy or sell at a reasonable price whenever one needs to do so. While reasonable price can mean different things to different people, it has come to mean, generally, one close to the last traded price. A liquid market is characterized by the presence of well-capitalized marketmakers, the availability of a two-sided market on demand, and a tight spread between the bid and offer. Without liquidity, buyers and sellers alike find it virtually impossible to establish a fair price for their assets. The growth of electronic markets has resulted in a massive increase in the amount of liquidity generally available to the marketplace. In the “old days” (less than a decade ago), anyone sending an order to the market had to rely on the liquidity provided by the market specialists, in the case of a stock exchange, or pit traders, in the case of a futures or options exchange. As few as a handful of traders or up to a few hundred would provide the entire pool of market liquidity, and it seemed like alot of liquidity. Now, by contrast, the entire world is linked together in a vastly expanded universe of capital, technological innovation, and market expertise. What once impressed us as alot of liquidity, seems as quaint today as a Model-T Ford might, to the driver of a Lamborghini.
There are two key drivers of the liquidity engine: the need for immediacy and the supply of immediacy. The need for immediacy occurs when, for example, a seller determines that it is more sensible to dispose of an asset rather than hold it in his portfolio. The price at which the seller is willing to dump the asset is a function of volatility and the risk involved in holding the asset, against the immediate benefit to be appreciated by liquidating. In order to get a price that justifies the sale, the seller looks to the marketmaker to provide a reasonable bid. The price risk, which the seller wishes to eliminate, is then transferred to the marketmaker. Marketmakers, however, are only willing to create immediacy if they are appropriately compensated for the risk they are taking. In order to show a profit they must not only buy low and sell high, but also cover the direct costs associated with carrying out their transactions, for exapmle, exchange fees, commissions, cost of exchange memberships, salaries and benefits, etc. They also have to cover their opportunity cost. In other words, if the firm can deploy its’ capital better by using it for things other than marketmaking, it will do so. In the end, though, the degree of risk a marketmaker is forced to assume is the central determinant of the bid and offer he provides. Taking a look at the liquidity model as a whole, it is fair to say that the conditions for an extremely liquid market are present when the demand for immediacy is high and the cost to the marketmaker of maintaining a continuous presence is low.
In highly volatile markets, the demand for immediacy is extremely high, as is risk to the marketmaker. This may mean that liquidity is diminished. It may, for example, be unrealistic to expect that a stock or derivative will trade in the same tight price increments as on days when volatility is low. But heightened volatility can benefit marketmakers because it allows them charge nervous investors an additional premium in return for immediacy. At some point, however, when volatility gets out of control, the marketmaker is no longer willing to assume the risk of marketmaking. The fear is that no amount of price-edge can sufficiently insulate the marketmaker from being stuck with a position from which he cannot extricate himself. It’s kind of like the famous short story, The Bottle Imp, by Robert Louis Stevenson, but in reverse. In the story, good fortune accrues to the owner of a magic bottle who can convince someone else to purchase the bottle for less than the owner paid. But woe to the owner of the bottle who buys it for a penny, the lowest coin in the realm, for he will not be able to find a buyer and will spend eternity in hell. In an illiquid market there is nothing you can do to entice a marketmaker to make you a price, lest he acquire an untradable position, which represents the marketmaker’s private hell. In such an environment, sellers inundate the few bottom-feeding buyers that are willing to try to pick the low and who, then, become sellers themselves when the market continues to fall. Very quickly, absent an external force entering the market—such as a central bank, government, or respected investor— prices spiral downward, the fall accelerating as the panic grows.
The best analogy to explain this phenomenon is to consider what happens during a run on a bank. Generally, individual accounts, even large ones, are highly liquid and the bank is generally able to satisfy all withdrawal requests. This is because there tend to be deposits every day, as well as withdrawals, and they more or less balance out. The problem arises, however, when depositors question the ability of the bank to live up to its obligations and redeem withdrawal requests. In those situations, it is only natural for the depositors to want to get their money out of the bank as quickly as possible. The ensuing run ultimately forces it to close, turning depositors into creditors. In these situations, ironically, it is the depositor’s very belief in the liquidity of the bank—that one’s money is available for withdrawal at any time—that ultimately causes it’s demise.
Markets are subject to the same pressures as banks, when investors and traders decide they want to get out of their positions at any price. Typically, runs on the market will commence with an imbalance of orders in the opening minutes of the day. As the brokers for retail and commercial users flood the system with sell orders, the marketmakers are eventually overcome and adjust their inventories by dumping the shares they have purchased in the initial selling wave. As the market breaks further, it draws the attention of speculators, such as hedge fund managers and day traders, who see an opportunity to profit by selling short. Technicians, who initiate trades when markets break through support points, enter their sell orders as well. At some point, just as the bank runs out of money, the market runs out of liquidity. This is exactly what happened on October 19, 1987, and by day’s end the market had fallen 22%.
In most cases, market runs tend to diminish in intensity when buyers, seeking bargains, prop up share prices, calming the turbulence. In fact, in one of the most famous stories to emerge from the abyss of the 1987 crash occurred on the day after, October 20th. That day, the market opened encouragingly higher, but soon experienced a dramatic sell-off, adding to the previous day’s losses. Fearful of a total meltdown, with no liquditiy in sight, the New York Stock Exchange, Chicago Board Options Exchange, and Chicago Mercantile Exchange shut down their trading systems. The hope was that a “time-out” might allow everyone to catch a collective breath and focus on finding bargains at the new lower valuations (in the aftermath of 1987, the SEC and the exchanges mandated automatic downside “circuit-breakers” that kick in at various thresholds and force a market halt for a brief period of time. The idea behind the circuit breakers is that if the market truly needs to go lower it’ll get there eventually, but that it shouldn’t do so simply because investors are panicking). But while the exchanges at the center of the securities trading world had run out of gas, the Chicago Board of Trade left open its’ tiny Major Market Index contract (MMI), a second-tier stock index future that normally attracted little attention from the investment community. Today, however, the MMI would get its’ 15 minutes of fame.
At that dire moment, the only trader on the planet willing to provide a bid was legendary Market Wizard, Blair Hull, who bought 150 MMI contracts, at what turned out to be the exact low of the move, a trade on which he reportedly made $4 million. With no other bid to rely on, no place to go if the market continued to collapse, Hull’s liqudity was as pure as a mountain stream. His willingness to bid when the market seemed bottomless, gave other traders the courage to enter the market as buyers as well. This was significant because most traders are too chicken to do anything without company, which highlights to an even greater degree the enormity of Hull’s marketmaking bravado. This wasn’t simply sticking a toe into a depleted pool, but high diving into a tiny bucket. The dive had to be perfectly timed and executed and when the judges raised their scorecards the dive was a 10 across the board. After that, everyone wanted to take a turn, and some measure of liquidity was restored to a marketplace desperately in need.
But what would happen if no buyers emerged;? If ever lower stock prices were perceived not as a great value, but an indicator of the market’s shattered foundation? While the boom/bust cycle implies that the market always recovers (even if only to falter yet again), it’s not that simple. Some markets often suffer for years after a cataclysmic market event. In October 1987, Hong Kong’s benchmark Hang Seng Index, fell 50 % after a 4-day market halt and took a few years to recover, even as U.S. and European markets gained back all they had lost and then some by the end of 1987 (not even a Market Wizard could help the Hang Seng). Other crisis situations over the years, particularly in emerging markets, have repeatedly undermined investor confidence, making it increasingly difficult to entice them back after the fall. This leads to the proverbial vicious cycle: lost investor confidence results in lost liqudity and without liqudity it is almost impossible to inspire investor confidence.
This phenomenon is real and the G-8 economies are not necessarily immune from the negative consequences. For example, no one knows how the current subprime lending crisis will turn out, but with a lack of liqudity in the credit markets, it seems likely that banks, mortgage companies, and builders will no longer be able to offer easy credit terms to buyers. As a result, current mortgagees will find it difficult to refinance their loans at attractive rates, as their artifically low “teaser rates” reset many percentage points higher. At the same time, home prices will drop due to a dearth of buyers, and many homeowners will find that they owe significantly more than the homes are worth. If the economy falters and wages drop or unemployment rises, banks may find themselves back in the foreclosure business for the first time since the Savings and Loan Crisis in the 1980s.
So it goes. Maybe, one day, the liquidity crisis will come that will continue endlessly, maybe this will be the one. But probably not. If houses are going for fire-sale prices, chances are that confident liquidity providers will eventually line up to dive into the bucket, and they’ll undoubtedly be rewarded for their risk-taking. This is the nature of the market, the nature of liquidity, as any economist or monkey knows.