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Why bank regulation, algorithmic investing, and QT has put markets at risk of a systemic event.

Why the toxic combination of bank regulation, algorithmic investing, and QT has put equity and bond markets at increased risk of a systemic event.

The above quote comparing liquidity to leverage comes from Goldman Sachs’ head of Global Credit Strategy, Charles Himmelberg. Historically, leverage “is the tinder that turns a financial fire into an inferno,” as The Financial Times put it recently. However, since February’s flash crash, Himmelberg has again and again sounded the alarm that the algorithmic transformation of markets means liquidity, not leverage, should be the preeminent, catalytic concern as quantitative tightening progresses and volatility returns. “I routinely field questions from clients asking where the risks are building up, and this is the one I worry about,” he told The FT earlier this month. “Financial markets have changed pretty dramatically since the crisis.”

In these pages, we have sought to understand the implications of the algorithmic and passive revolution, one of the most profound changes to the global financial system in history. And we keep coming back to liquidity as the key threat — if a market shock causes algorithmic strategies to simultaneously unwind or the passive herd to flee, supply could rapidly overwhelm demand, causing widespread panic. Now, mounting evidence suggests the threat is intensifying. Speaking to The Wall Street Journal, Jeffrey Cleveland, chief economist at Payden & Rygel, put current market liquidity in stark terms: “It’s like going into a grocery store and there’s nothing on the shelves.”

Whether inflation, interest rates, margin pressure or a domestic or global political crisis, it is not yet clear when a market shock will come and what will be the catalyst. However, the more threats mount, the more essential it becomes to understand how an ever-illiquid market might react under stress. Based on all available evidence, pain will come far faster and with far greater severity than most anticipate.

Post-crisis bank regulation is at the heart of the liquidity problem. As The FT documented recently:

“Since the financial crisis, regulatory changes have aimed to purge leverage from the system, primarily by severely curtailing the role that banks have traditionally played in providing liquidity…Instead of relying on balance sheets to lubricate trading, banks have become more like brokers and embraced the algorithmic techniques of high-frequency traders…On the whole this has made markets more efficient, with the difference between the price investors have to pay or will receive for a financial asset — the “bid-ask spread” — narrowing to record lows. By this measure even the bond market today looks more “liquid”. But some analysts and investors said markets that may seem superficially more efficient were more prone to “liquidity crises”, where waves of sellers suddenly overwhelmed the depleted capacity of market-makers such as banks to absorb and intermediate the buy and sell orders.”

According to Mauldin Economics, Dodd-Frank requirements have reduced major bank market-making abilities by as much as 90%. In more anecdotal terms, Goldman Sachs’ president David Solomon told The FT that the bank used to have 500 people dedicated to making markets in equities and now has only three. A similar dynamic is apparent in the bond market. In a paper released in October, “Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs”, the Federal Reserve Board concluded: “Among trades where customers are demanding liquidity” — where dealers aren’t just matching customers, but actually providing immediacy themselves — “we find that these customers pay 35% to 50% higher spreads than before the crisis.”

Post-crisis regulation has no doubt made “too big to fail” banks less vulnerable to violent market swings. According to a recent study of nine big European and U.S. investment banks, hedge fund Capstone concluded that aggregate “value at risk” — a rough measure of how much the banks can expect to lose on any given day in markets — had fallen from a peak of roughly $1.9 billion in 2008 to $377 million at the end of 2017. The problem is, regulation didn’t eliminate the risk, it just transfered it from big banks to remaining market participants. Meanwhile, big banks are not there to serve as the backstop in the event of a spooked market, providing liquidity by buying into dips.

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