‘Air Pockets’ And Risk Hiding In Plain Sight

You know, I think one of the reasons why investors in general and retail investors in particular don’t appreciate the risks inherent in changes to market structure is because a lot of those changes have come in the post-crisis era.

I’m just guessing, but given that Lehman was damn near a decade ago, it seems entirely likely that a non-negligible percentage of the people running around on the sellside and the buyside right now were in high school when Congress voted on the bailout in October 2008.

Given the above, I think it’s entirely fair to say that there is a sizable contingent of market participants out there who i) do not know of a reality that’s any different than the current reality characterized as it is by passive flows, algos and other “innovations” that have the potential to create problems, and ii) if they are aware of how the landscape has changed, they don’t believe the new landscape is dangerous because they’ve literally never seen a two-way market.


Some of the commentary I read now from folks who understand the risks has a fatalistic feel to it – almost like the people writing it have grown weary of stating what to them is obvious, but what to most people is seen as either fearmongering or to the extent it has merit, is immaterial because after all, nothing ever goes wrong.

It’s with that in mind that I wanted to highlight the following brief passage from Goldman’s latest. You can read more highlights from their note here, but I wanted to give this one its own post because it underscores my contention that there are risks embedded in modern markets that are hiding in plain sight.

Here’s Goldman, presented without further comment because everything said above should be more than enough in terms of context:

Increased leverage and changing market structure raise the risks of technical ‘air pockets’

While the macro risk factors triggering a recession appear low, technical factors could mean that a correction in the current environment would be more painful than investors expect. Market structure has changed radically in recent years. Margin debt on exchanges has increased rapidly (Exhibit 19) and passive fund flows have dramatically outstripped active flows in recent years. As Exhibit 20 shows, flows into ETFs were roughly five times the size of flows into active funds in 2017. It is not clear what would happen to demand in passive funds during a drawdown. For example, any losses in bond ETF funds could be more painful than an equivalent loss in underlying bonds held by investors, as the funds do not provide investors with a coupon to maturity. If investors faced losses and wanted liquidity, this could well spill over into other markets such as equities.


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