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Market liquidity, or how easily investors can buy or sell a
security without affecting its price, has been on a downward
spiral for years. In recent weeks, however, traders have been
whipsawed by massive moves.
"Liquidity is abysmal, is the way I would describe it," said
Rishabh Bhandari, senior portfolio manager at alternative
investment management firm Capstone Investment Advisors.
"As soon as anyone wants to move risk, there isn't an efficient
mechanism for folks to be able to do so."
Analysts said liquidity has been hurt as active investors who
buy and sell opportunistically have been overshadowed by
automated trading and passive investment strategies. They also
blamed tighter regulations that have discouraged risk-taking by
some brokers.
On Thursday, for instance, Facebook parent Meta Platforms
plunged in the biggest daily slide ever for a U.S. company
stock, losing more than $200 billion of market value.
Wall Street's fear gauge, the Cboe Volatility Index rose last
month to a 15-month high of 38.94, amid a plunge in stock prices
that left the Nasdaq down 9% and the S&P off 5.3% in January in
the face of a hawkish shift from the Federal Reserve.
The liquidity problem is not restricted to individual stocks.
E-mini S&P 500 futures, one the world's most widely followed
financial instruments, are also flashing a danger sign.
Low liquidity exacerbates market swings and makes it harder for
investors to execute buy and sell orders at a desired price.
Episodes of scant liquidity contributed to wild market gyrations
in March 2020, when the S&P 500 fell by about a third, peak-to
trough, as investors worried about an economic shutdown related
to COVID-19.
One measure of equity market liquidity is the market depth of
S&P 500 e-mini futures, which investors use to gain exposure to
the U.S. stock market.
These futures trade usually about $50 million of notional value
at any given time. That number fell to around $2 million in late
January, not far from the $1 million - to $1.5 million level
touched in March 2020, data from Capstone showed. Now it stands
at just under $5 million.
(Graphic: Liquidity crisis,
https://graphics.reuters.com/USA-STOCKS/LIQUIDITY/znpnejlybvl/
chart.png)
Another liquidity metric shows the share of equity exchange
traded funds as a percentage of total equity volumes at 45%, the
highest in at least two years. Low liquidity in individual
stocks has pushed investors to increase their use of equity ETFs,
according to JP Morgan.
In addition to the March 2020 selloff, deteriorating market
liquidity contributed to equity market corrections in September
2021 and October 2020 and December 2018, JP Morgan analysts said
in a recent note.
"A similarly abrupt deterioration in equity market liquidity
conditions appears to have exacerbated recent market moves,"
they wrote.
Investors pinned the dearth of liquidity on a variety of
factors. For one, they said tighter regulations in the aftermath
of the global financial crisis curtailed large broker-dealers'
capacity to take risk.
Another factor has been the shift to market making for
securities from humans to machines. Trading programs sometimes
pull back liquidity when volatility spikes, experts said, which
can exacerbate market moves.
Also, some investors cited the rise of passive investment
strategies. While active managers looking for trading
opportunities have historically provided liquidity during times
of stress, systematic and passive strategies may not be allowed
to do so due to strict rules about how and when they can trade.
"Liquidity risk is grossly under-appreciated," said Steve
Sosnick, chief strategist at Interactive Brokers and a former
options market maker.
"As investors crowd into winning stocks, they become oblivious
to the fact that it becomes increasingly difficult to exit en
masse.”
(Reporting by Saqib Iqbal Ahmed; Editing by Ira Iosebashvili and
David Gregorio)
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