Understanding the behaviour of different participants during a shock is an essential first step to improving the resilience of financial markets to sudden periods of illiquidity.

Financial crises occur because of the joint effects of leverage and illiquidity. Leverage causes forced liquidations, and illiquidity creates the downward cascades and contagion that result. The regulations that have come in the wake of the 2008 crisis have focused on stemming leverage, but have largely ignored liquidity. In fact, in their focus on leverage they have unwittingly heightened the vulnerabilities from liquidity. In reducing the balance sheet of the banks, Basel has also reduced their capacity to hold inventory. In moving the banks away from proprietary trading, the Volcker Rule has reduced the profitability of the broker-dealers’ market-making function, reducing the incentive to take on positions during periods of high volatility and one-way flows.

Unlike leverage, illiquidity is difficult to assess, so its risks are largely hidden. It is true that day-to-day liquidity is readily visible and can be measured by looking at indicators such as bid-offer spreads and average daily volume, but day-to-day liquidity is not what matters. The liquidity that matters is what is available during periods of market dislocation when liquidity demand is many multiples of what is normally seen. And what happens in a typical day gives us little sense of that, not only because the size of the flows is smaller, but also because trading is carefully managed in the normal market periods in order to avoid moving the market.

Dislocated thinking

Dislocation dynamics were at play during the Flash Crash on May 6, 2010. I was working at the US's Securities and Exchange Commission at the time, and was enlisted to figure out what had gone wrong. There were any number of reports and investigations on the causes of the Flash Crash, but the essential dynamic was simple. Many investors kept stop-loss orders in place, and did so as market orders. The replenishment of the order book could not keep up with the essentially instantaneous triggering of these market stop-loss orders, even with the microsecond speed of the high-frequency traders. And the market cascade came with a one-two punch: first prices dropped precipitously as market stop-loss orders ran through the order book; then, with the prices in disarray, many liquidity providers pulled away from the market to recalibrate their market activity, leading prices to continue their cascade, in some cases to absurd levels.

In this case, contrary to the tenets of demand theory, the rapid drops in price did not open the spigot of liquidity supply nor did they stem liquidity demand. Indeed, they did the opposite. The drop in prices led to further forced selling and spooked those who might have come to take the other side of the market.

This case was in the equity markets, but the same can happen, with far greater systemic implications, in the rates and credit markets supported by the bank/dealer market makers, and their weakened position may make the effects all the more devastating.

Learning the lessons

The events of May 2010 tell us how to model crisis-level illiquidity, and also suggest the approach to buffer its impact. Liquidity shocks such as this occur when margin calls force the liquidation of leveraged positions, and there is a widening disparity between the reaction speed of the liquidity demanders and the liquidity providers. Those who are forced to sell must take action with great urgency. Those who are providing liquidity do not face similar urgency. Their decision cycle might involve consulting with others in their firm or reformulating a broader investment plan before taking action.

That is, the frequency with which agents arrive at the market is heterogeneous among market participants. Liquidity appears to dry up because of the heterogeneous arrivals, and more to the point because the liquidity demand has a greater frequency of arrival than does the deep-pocket supply from large institutions. Impatience reduces the effectiveness of price as a signal.

How can this sort of liquidity dynamic be dealt with? First, there is a need to measure the potential for illiquidity. To do so, we need to model the heterogeneity of agent arrival. The natural tool for doing this is agent-based modelling. The liquidity demanders, liquidity suppliers and market makers all comprise different types of agents, each with different objectives. I developed several models of this type while at the Office of Financial Research in the US Treasury.

Second, finding a regulatory solution for the rising risk of crisis-level illiquidity is needed. We must either increase the capacity of market makers or find ways to bring new market makers into the fray. We need to reduce the asymmetry in the decision cycles of the liquidity demanders and suppliers during crises. This can be done on the liquidity demanders’ side by reducing the speed of liquidation. One way to do this is through circuit breakers. Another is to increase the time allowed for liquidations.

On the liquidity suppliers’ side, we can facilitate them coming into the market more quickly. A starting point for this is to develop methods for the liquidity suppliers to assess when a market dislocation is occurring due to liquidity supply as opposed to other causes.

Richard Bookstaber is the chief risk officer at the University of California’s Office of the Chief Investment Officer. He was previously a research principal at the US Treasury’s Office of Financial Research.

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