Liquidity, or a lack thereof, was a hot topic in August, just as it’s been during every other turbulent month since February 2018’s VIX ETN “extinction event”.
Modern market structure has made things more fragile during times of stress even if, on a day-to-day basis (i.e., during “normal” times) the upside in terms of efficiencies, etc. far outweighs the downside.
As we’re fond of putting it, 2018 might very fairly be described as the year when it dawned on a wider swath of market participants that the feedback loop between systematic flows, volatility and liquidity is a real thing — not just some theoretical construct yanked from a quant note and amplified by blogs of ill repute. In 2019, the liquidity discussion is had daily.
Read more about liquidity in August: As Manic Market Moves Metastasize, Mind The Liquidity Drought
Although last month provided no shortage of examples of price action being exacerbated by modern market structure and seasonally thin market conditions, Goldman sees scope for improvement going forward.
“If we look at the average top-of-book depth when the VIX is between 20-25, we see that it was higher in May and August than was experienced during similarly stressed times in 2018 and early 2019”, the bank writes, in a note dated Tuesday.
Goldman goes on to say that although single stock liquidity is still stuck some 20% below its 10 year average, liquidity should increase this month. For the past three years, September “has been the highest liquidity month of the year”, the bank observes.
Still, it’s probably best to cast a wary eye. After all, modern market structure isn’t going to get any less “modern”, if you will.
In the same note, Goldman goes back over what the bank calls the “three primary drivers of the evolution of liquidity” and first on the list is the Electronification of market making.
“Markets dominated by computers have different characteristics than those run by people”, Goldman reminds you, on the way to reiterating that ‘computers don’t have the benefit of being able to carefully weigh the true meaning of fundamental events, so they are programmed for the safety of their owners”.
JPMorgan’s Marko Kolanovic has been warning about this for years. Recall this passage from “Risks of Market ‘Uberization'” (more excerpts here):
What is the reason for such a dramatic drop in liquidity? The most important driver is likely the increase of volatility (e.g. VIX), given that many market making algos (as well as business models) were calibrated during the years of low volatility. 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.
Goldman reiterates that on Tuesday.
“Electronic market makers widen their quotes in microseconds when they sense a significant increase in volatility or can predict the potential for volatility”, the bank says, adding that “we know this is a key driver of the evolution of liquidity as markets dominated by electronic market making have seen larger drops in liquidity during periods of stress, while markets that continue to be dominated by human market making (Credit) have seen more stable liquidity”.
On that note, we’ll leave you with two last charts to ponder from JPMorgan’s Josh Younger and Munier Salem who last month cautioned that “low latency participants have grown to represent a majority of liquidity provision in US rates markets, but their presence is vol-dependent”.