What Happens When You Have To Play That Piano Drunk? Or, The Most Absurd Thing I Heard All Day

You’re really good on the piano. I mean, when it comes to the black and white keys, Alicia ain’t got sh*t on you. You’re probably going to be a concert pianist.

But then, a venerable Wall Street firm comes along and, because you also happen to have a knack for cash flow analysis (and an uncanny ability to suffer the deepest depths of boredom), offers you an attractive salary to move to the city. You go over to the dark side. There’s no room in your 650 square foot apartment for a piano, so you stop playing.

A decade passes.

You work your way up in the firm and eventually you ingratiate yourself with the upper crust. One night, while sipping Veuve Clicquot (everyone is slumming it that night because someone who will soon be jobless forgot to restock the Perrier-Jouët) with your friends at a getaway in the Hamptons, you’re asked to demonstrate your long, lost skills on the piano.

Between being tipsy and having not played in 10 years, things don’t go so well. People laugh. You get dizzy. You vomit in someone’s Hermès bag.

That little vignette is meant to demonstrate a simple point: when something isn’t used, it falls into disrepair. You may remember how to play the piano, but you’ll be rusty if you don’t practice.

Well the same is true of markets. Consider the following quote from the NY Fed:

The strategic substitution away from bonds to CDS further decreases liquidity in the bond market relative to the CDS market, contributing to the widening CDS-bond basis.

Don’t worry so much about the specifics there if you don’t understand them. Just focus on the overarching point. Colloquially: when you stop using some sh*t (the cash bond market in this case, your piano skills in the example above), that sh*t eventually stops working (markets become illiquid, you’re rusty on the keys).

The excerpt there is from a NY Fed study that highlights the shift away from cash markets and into derivatives. The rationale for that shift is that derivatives offer more liquidity. But there’s a problem. Here’s how I put it in the second most read post in this site’s brief history:

These shifts could well create a self-feeding dynamic. That is, the more you rely on derivatives, the less you’re trading the cash markets. The less you trade the cash markets the more illiquid those markets become. The more illiquid the cash markets are, the more you turn to derivates as a more liquid alternative. And around we go. The “solution” (migrating to derivatives) makes the original problem (a lack of liquidity in the cash market) that much worse.

Well guess what an ETF is? It’s a f*cking derivative. I don’t care what anyone else tells you. And do you know what the proliferation of ETFs has catalyzed? That’s right, a shift away from the actual markets for the assets that underpin the ETF units.

This is a disaster for the corporate credit market. The more investors and fund managers swap ETFs and portfolio products to match flows, the more illiquid the market for the underlying assets becomes. It’s really simple. Here, look (the first flow chart is pre-crisis, the second, post-crisis):


(Charts: Barclays)

Dealers (banks) can’t serve as middlemen in the post-crisis regulatory regime (the cost of balance sheet is huge). So, there’s essentially no market for the actual bonds that lay sleeping beneath the veneer of ETF liquidity.

Now then – and this part is critical – note that in the second chart above one side is “manager with outflow” and the other side is “manager with inflow.” This is conceptually the same as “investor selling ETF”, “investor buying ETF.”

Well, what happens if the flows aren’t diversifiable? What happens if they’re unidirectional? What the f*ck happens if everyone is selling and there’s no dealer buffer?!

I’ll tell you what happens. Suddenly, the underlying bonds have to be sold to meet redemptions. But like your piano skills, that market is rusty. Do you know what the market equivalent of vomiting in a Hermès bag is? It’s called a firesale.

So with that in mind, read this from none other than Vanguard, the supposed bastion of sanity in an otherwise insane world (note the highlighted passages):

ETFs differ from MFs largely because of the way investors transact in fund shares, and these differences provide ETFs with additional benefits in terms of secondary market liquidity and market-based prices. Secondary market transactions represent an additional source of liquidity for investors while market-based prices reveal valuable information about market conditions. Secondary markets provide an additional source of intraday liquidity ETFs give investors the flexibility to trade shares intraday, and this intraday trading is recorded as trading volume on the various European stock exchanges. However, the overwhelming majority of this trading reflects secondary market transactions (i.e., trading of ETF shares between two market participants), and only a very small amount results in primary market trading (i.e., trading in the underlying securities market). The secondary market provides investors with an additional source of liquidity, meaning they can trade a broad portfolio of securities without trading in the underlying market. 

During the course of the trading day, investor orders to buy and sell ETF shares are matched on an exchange with the help of market makers. At the end of the trading day, if market makers have a net short position in shares of an ETF (i.e., they sold more than they bought) or a net long position (i.e., they bought more than they sold), they might decide to offset those positions by seeking to create new shares or redeem the existing shares. ETF creations and redemptions are usually executed once per day using an NAV derived from the closing market prices of the underlying securities.

Figure 3a shows the percentage of daily equity ETF trading volume conducted solely on the secondary market. The median ratio was 99%, suggesting that for every €1 in trading volume, only 1 cent resulted in primary market trading. Put another way, 99% of the trading volume resulted in no portfolio management impact and no trading in underlying securities (Figure 3b shows the same analysis for bond ETFs – the median ratio here was also 99%).

See a problem with that analysis? Because I sure as hell do.

They’re mistaking the problem for the solution!

Only 1 cent of every dollar (or euro, or whatever) in trading volume actually results in the trading of the underlying securities.

What do you imagine that means for those underlying markets in terms of being able to efficiently price assets?

What happens when suddenly everyone is selling and those markets have to shoulder a greater part of the volume burden?

What happens when you have to play that f*cking piano drunk?

Now think on that.



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