The illusion of liquidity is a trap for investors in troubled markets

Das Capital: Investment horizons have become shorter, as many look to sell to a ‘greater fool’ trading the momentum suck liquidity out of markets when prices fall

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The Independent Online

The continued volatility of financial markets has highlighted a major problem: the lack of liquidity.

Trading liquidity – the ability to buy and sell financial assets such as shares, commodities or currencies readily – is frequently overestimated by investors and fund managers. Only a few stocks, major currencies and some government securities trade consistently and in large volumes. When market conditions are unfavourable it can evaporate – as the junk bond creator Michael Milken said: “liquidity is an illusion … It’s always there when you don’t need it, and rarely there when you do.”

At the moment, trading indicators give the appearance of robust normality. Trading volumes are high, particularly in bonds where they are at record levels. Spreads (the difference between the bid and offer price for a security) are small. The emergence of electronic trading and also a variety of investors gives the impression of a highly liquid market.

But market turnover – the volume of trading relative to outstanding securities – in bonds and shares has fallen significantly.

Government and corporate bond turnover is down about 50 percent, in part reflecting the massive growth in issuance.

There are several factors which are driving the problem.

First, central bank policies of low rates and quantative easing have driven investors into riskier, less liquid assets in search of returns. Large purchases of bonds by central banks have created an artificial scarcity of low-risk securities. Investors have been forced to invest in longer-dated securities, corporate bonds and emerging market issues. In many cases, the issuer is of low, non-investment grade credit quality. They have purchased less actively traded shares or invested in smaller and often less developed equity markets. Investors may not actually recognise that the additional return received does not compensate for the additional risk of reduced trading liquidity.

Second, with markets and prices increasingly driven by changes in official policy, investment horizons have become shorter. Many investors are purchasing assets for short-term gains on the assumption that they will divest positions to a “greater fool” before any fall in prices. This game of investment musical chairs relies on anticipating when the tune will stop, which history shows most market participants are poor at.

Third, the nature of investors has changed. It now includes more investment funds, exchange traded funds and specialised investors (such as high frequency traders).

ETFs, which replicate a benchmark index, have about $3trn in investments. Bond funds have more than $7trn in investments, up $3trn on 2009. Much of the new funds have gone into less liquid securities such as corporate bonds. In the US, investment funds hold 20-times as many bonds as banks today, against just three times before 2007.

Markets are dominated by a few large investors and there is significant herding behaviour. Similar portfolios and strategies exacerbate risk and illiquidity if a large number of participants wish to exit positions at the same time.

Investors are frequently following the market and trading the momentum: buying when prices go up and selling when they fall. They are users rather than providers of liquidity. Their buying creates the illusion of active trading when markets are rising but suck liquidity out when prices fall.

Fourth, many investment vehicles now promise greater liquidity to their investors than that of the underlying investments which they hold. Funds frequently promise investors to redeem their investment within seven days. Some ETFs even promise intraday redemptions. The problem is that the fund investments may be insufficiently liquid. The IMF found that a fund investing in US high-yield corporate bonds might take up to 60 days to liquidate a holding, well in excess of the time available to meet investor redemption requests.

While funds can delay or suspend redemptions – a process known as gating – in the 2007 crisis, such behaviour fuelled uncertainty and increased selling pressures in other assets as investors sought to raise cash and reduce risk.

Fifth, there has been a sharp contraction in the market-making capacity of dealers, particularly in bonds.

Perversely, central bank policies have simultaneously created an abundance of money and a contraction of liquidity. Investors are likely to have greater difficult in selling their holdings, especially when these are large.

Satyajit Das is a former banker and author whose latest book, ‘A Banquet of Consequence’, will be released in February 2016