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Liquidity Shock: the Hidden Risk in Modern Markets March 2018 Investment Intelligence Liquidity Shock: The Hidden Risk in Modern Markets March 2018 Introduction Post-crisis changes to regulations and market Key Takeaways structure have combined with innovations in technology and financial products to make global Today’s markets contain hidden risks that markets more robust and efficient. Despite this increase vulnerability to volatility spikes and progress, today’s markets still contain risks that liquidity shortages. increase vulnerability to volatility spikes, episodic The main sources of these risks are financial Steven Malin, PhD disappearances of liquidity and, potentially, another product innovations, automated and algorithmic Director liquidity crisis. The main sources of these risks are trading practices and regulatory adjustments Senior Investment the ongoing stream of financial product innovations, Strategist put in place to strengthen markets after the automated and algorithmic trading practices and, Global Economics 2008 crisis. & Strategy ironically, some of the very regulatory adjustments put in place to strengthen markets after the Also contributing to more “accident prone” 2008 crisis. markets are diminished bank bond inventories, Together, these factors have the potential to turn the growth of high-frequency trading, and the a small market disruption into a rapid collapse of proliferation of ETFs and rules-based trading asset prices—a danger that became all too real strategies. to investors during the sudden and dramatic reappearance of market volatility in February These risks could be exacerbated in coming 2018. Over the coming decade, these risks could years by unprecedented “quantitative be exacerbated by unprecedented “quantitative tightening” by central banks. tightening” by central banks that could cause funding Institutional investors should act now to account liquidity and, ultimately, market liquidity to shrink. for potential liquidity shortages in their risk Exhibit 1 (next page) illustrates how complex management practices. interactions among this web of factors could be making markets more “accident prone.” Protecting a portfolio against liquidity shocks requires a system to identify early or predictive Institutional investors who fail to account for signs of a shock and palliative actions in case a resulting potential liquidity shortages in their risk liquidity shock occurs. management practices are likely to find themselves in the dangerous position of having to scramble for Congress and regulators should work together liquidity in disorderly markets to protect against to put in place micro- and macro-prudential losses or meet regulatory requirements. measures that can minimize risks to liquidity In this paper, we identify and assess the factors availability, help build investor confidence and, contributing to liquidity risk and provide potentially, soften liquidity shocks. recommendations on how institutional investors can protect their portfolios from future liquidity shocks. allianzgi.com Liquidity Shock: The Hidden Risk in Modern Markets Exhibit 1: The financial infrastructure is more fragile than it seems Feedback loops create hidden instabilities $15T Massive Public Passive Flows Public Flows 1 $ 15T printed in the last 10 years by major central banks, $3.6T just in 2017 2 Trending bull markets (trend factor) 3 Financial repression of volatility (volatility factor) Positive feedback loops $8.6T Creates system instability and with private investors Private Passive divergence from equilibrium Assets $8T of which is now passive Active Machine ETF and Passive Risk Parity & Vola- Short Volatility Trend ARP & Factor Investors Go EXIT: Value Index Funds tility Target Funds ETF Funds Algos Investing Learning & AI With Investors, $0.1 T Bears $4T $3.75T $0.05T $0.5T $0.25T the Flow Unstable Equilibrium: Massive high-beta Short volatility and Illusory diversification a state in which a small Long-bias in disguise trend-chasing crowding in Illusory liquidity disturbance produces a Hot money flows private passive flows large change Source: Fasanara Presentations “Market Fragility: How to Position for Twin Bubble Bust,” October 16, 2017, Allianz Global Investors As the financial system strengthened, markets and better quality capital, an innovative stress testing regime, new became more liquid liquidity regulation, and improvements in the resolvability of large firms.” Stress tests—as well as multilateral accords that increased During the Great Financial Crisis of 2008, liquidity shrank dramatically banks’ risk-based capital requirements and limited the amount of or dried up entirely in the LIBOR, repurchase agreement, short-term leverage banks can take on—provided a buffer against credit-related commercial paper and other large-volume money markets. The cost losses, while new laws like Dodd-Frank created a new, deeper source of short-term money soared as perceptions of counterparty risk of liquidity in the form of a modernized swaps market. became more acute. Illiquidity in the funding markets spread to the capital markets, which became unstable. Price discovery became Since the crisis, markets have also been made more efficient difficult, if not impossible, as counterparties sought safety in cash. mechanically by technological advances and product innovations. Trades are executed nearly instantaneously worldwide at transaction In response, financial market participants, regulators and central banks, costs that are a small fraction of what they were a few decades ago. especially, took powerful steps to make the banking and financial Fixed-income markets, especially, have been transformed as barriers systems more resilient and assuage fears that funding liquidity would to entry have fallen and new liquidity providers have stepped forward. become unavailable or unaffordable. These steps changed the Electronic trading platforms, post-trade infrastructures and steps to financial landscape permanently. enhance transparency have led to more open markets and away from In the midst of the crisis, monetary authorities were forced to step bilateral and over-the-counter structures. in to assure that illiquidity in specific funding markets did not lead to The new electronic infrastructure allows for a more diverse set of sequential disruptions that would make the entire financial system investors to participate, increasing competition and improving market inoperable. These actions proved highly effective. Unconventional liquidity. On many of the most volatile trading days, a new nonbank monetary policies drove interest rates to unprecedented low levels market entrant now consistently ranks as one of the top three liquidity that sustained a recovery in real economic growth and providers on the main electronic trading venue. During these volatile accommodated lengthy bull markets in both stocks and bonds. periods, nonbank participants have maintained tight bid-ask spreads As Randal Quarles, the US Federal Reserve’s Vice Chairman for while banks widened bid-ask spreads and, at times, withdrew Supervision, put it in a January 2018 address to the American Bar completely from the markets. Overall, due to nonbank participants, Association Banking Law Committee, new regulations and their bid-ask spreads are now meaningfully tighter, complex documentation enforcement “resulted in critical gains to our financial system: Higher has been eliminated, and risk has been reduced. 2 Liquidity Shock: The Hidden Risk in Modern Markets Meanwhile, funds tracking bond indices now hold more cash and Exhibit 2: Liquidity shortages exacerbated February’s spike invest increasingly in standardized derivatives that are more liquid in the VIX index than individual bonds and can be sold without much loss if funds Feb 5, 2018 bid-ask spreads on VIX face a rash of redemptions. Information flows more freely and is Bps distributed more widely, and prices are readily available to virtually 50 * all participants to discover. UX1 VIX Bid VIX VIX Ask In sum, these changes have addressed many of the systemic risks 40 seen as causes of the Great Recession and made markets more robust, resilient and efficient. 30 Redesign of the financial landscape may have elevated liquidity risk, too 20 Despite these significant improvements and the availability of ample liquidity in most asset markets through January 2018, the banking and 10 9:31 10:31 11:31 12:31 13:31 14:31 15:31 financial systems remain vulnerable to many of the same liquidity- zapping risks that created distress during the Great Financial Crisis. * The front month VIX future index In fact, some of the steps taken in the wake of that crisis have actually Source: Barclays Research, Bloomberg contributed to higher levels of liquidity risk. The market provided an unnerving example of this cascade effect Systemic liquidity has two components: market liquidity and funding in February 2018. On Feb. 5, the Dow plunged 1,175 points, or 4.6%. liquidity. Although the two types of liquidity are distinct, they are closely Exhibit 2 illustrates the corresponding spike in the VIX index—a related and, often, mutually reinforcing. When funding liquidity is not sudden move that was triggered initially by the equity market sell- abundant, traders do not have the resources with which to finance off but was fueled largely by a decrease in liquidity, as depicted by the trading positions that smooth out price shocks and sustain orderly the newly expansive gap between VIX bid and ask spreads. markets. Next, volatility worsens and trade financing becomes stifled. The sudden
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