As the punditry continues to insist that because the fundamental backdrop is sound, nothing too bad can happen, people seem to have learned nothing (or very little) from the technical selloff that unfolded early in February.
The events that transpired on Monday, February 5, laid bare the risks of modern market structure. The rebalance risk inherent in the structure of levered and inverse VIX ETPs was realized and amid the turmoil, liquidity seemed to be sparse. The concurrent VIX spike (the largest in history), triggered a cascade of de-risking from the same systematic strats that some folks have been warning about for years. By the time that was over, some $200 billion in equity exposure was forcibly unwound.
While the bond selloff exacerbated by the above-consensus AHE print that accompanied the January payrolls report did indeed contribute and while there’s certainly an argument to be made that the week prior was actually the critical week in terms of setting the stage for the rout, the events that transpired from February 5 through February 8 were quite clearly technical in nature and as such, underscored the inherent risks of what many believe is an increasingly fragile market.
Well on Monday, Goldman is out taking up this topic in a note that asks if “liquidity is the new leverage.”
After detailing the events mentioned above, Goldman writes the following:
We suspect the Feb. sell-off is symptomatic of a broader risk, namely, the rising ‘financial fragility” during the post-crisis period. By “fragility” we mean price volatility that arises not from changes in the fundamental outlook for markets, but rather from markets themselves. To be clear, indicators of market liquidity like bid-ask spreads suggest that liquidity conditions have been reasonably good during the post-crisis era. But we see several reasons to worry that “markets themselves” are becoming a bigger source of market risk than fundamentals.
Next, they pick up on what JPMorgan flagged two weeks ago and what many HFT skeptics and modern market critics have been arguing for years. Namely that the presence of algos, the relentless pursuit of speed at the expense of other considerations, and the effect the post-crisis regulatory regime has had on the more traditional ecosystem are, when taken together, dangerous. To wit:
In particular, new regulations and new technologies have caused a dramatic evolution of the post-crisis ecosystem for providing trading liquidity. In this new market structure, machines have replaced humans, and speed has replaced capital. While such changes have greatly reduced the need for equity capital, and are thus efficiency-enhancing, the same was also true about leverage and structured products during the run-up to the financial crisis. While the new ecosystem for providing market liquidity has arguably freed up equity capital for more efficient uses, it has also depleted the pools of capital that will be available for liquidity when the cycle turns.
Moving along, Goldman underscores yet another point that has been made time and again by the critics – namely that all liquidity is not created equal:
One conspicuous consequence of post-crisis evolution is that trading volumes in many markets are now dominated by high-frequency traders (HFTs). While bid-ask spreads and other indicators of trading liquidity appear to indicate liquidity has improved in markets where HFT has grown, the quality of this liquidity has not yet been stress-tested by recession. The recent experience of the “VIX spike” suggests there is good reason to worry about how well liquidity will be provided during episodes of market distress, and this is only the latest example of a “flash crash”. Regulators and researchers increasingly warn that HFT strategies can contribute to breakdowns in market quality during periods of distress.
Finally, in a particularly ominous passage, Goldman tells you what might happen in the event the new, exceedingly fragile ecosystem is stress-tested in earnest – essentially, they argue that a dearth/disappearance could cause the same type of harrowing price action as sustained periods of deleveraging:
So far breakdowns in the new liquidity ecosystem have been short-lived and relatively benign, in part, we suspect, because the fundamental backdrop has been strong. But under alternative scenarios where fundamentals have deteriorated, we worry that a future such a collapse in market liquidity could amplify sell-offs. This could contribute to price declines and possibly prolonged periods of financial instability in ways that are reminiscent of the price declines caused by financial deleveraging. While the analogy is imperfect and our uncertainty is high, we see reasons to think that “liquidity is the new leverage”. Like financial leverage during the previous cycle, the rapid evolution of the post-crisis market structure has been a period of exciting technological innovations, but also one of low volatility and untested complexity. Along with the uncomfortably high number of flash crashes in most major markets, this is why we think “markets themselves” belong on the short list of late-cycle risks to which markets are potentially complacent.
Ignore all of that at your own risk – just don’t come asking what happened when another February 5-type episode rolls around.