In the event another steep selloff in risk assets comes calling, it’s likely to be exacerbated by a lack of market depth.
At this point, that’s a statement that only bears repeating because the majority of market participants still do not appreciate the extent to which a dearth of liquidity contributes to exaggerated price swings.
In February of 2018 and then again in October and December, S&P futures depth was severely impaired, likely making things worse as stocks careened lower.
In a note dated Monday, Goldman’s Rocky Fishman (who, while at Deutsche Bank, documented the potential for inverse and levered VIX ETPs to eventually trigger an adverse market event) updates a familiar chart which illustrates the problem. “The dark blue bars indicate months where the size of bids and offers in the SPX futures market have been large (>$40m per side)”, he writes. “2018 and 2019 have been dominated by market depth that is between $1m and $20m per side (grey and orange)”.
Fishman attributes the regrettable shallowness to an “increase in risk aversion among the increasingly electronic market makers in futures”.
This is a familiar refrain and it echoes the concerns JPMorgan’s Marko Kolanovic has voiced for years.
“What is the reason for such a dramatic drop in liquidity? The most important driver is likely the increase of volatility, given that many market making algos (as well as business models) were calibrated during the years of low volatility”, Kolanovic wrote last summer, describing the 90% drop in market depth that accompanied the February 2018 VIX event. “As these programs don’t have an obligation to make markets and are optimized for profits, they likely adjust quotes and reduce size in order to maximize their own Sharpe ratio”, Marko continued.
The “liquidity-volatility-flows” feedback loop came calling again in December to dramatic effect. It’s also likely that the “V-shaped” character of the bounce off the Christmas Eve lows is in part due to low liquidity (impaired market depth exaggerates moves on the way up as well as on the way down).
“SPX futures liquidity has declined to its 15th percentile relative to the past 5 years”, Goldman’s Fishman cautioned, in the same Monday note.
On the bright side, single stock liquidity is back near the 66th percentile relative to the past decade, rebounding nicely off the December nadir. Goldman attributes the improvement to “a greater decrease in single stock volatility than volumes”.