Systemic Liquidity Risk and Bipolar Markets

Wealth Management in Today's Macro Risk On / Risk Off Financial Environment

Clive M. Corcoran

• Publisher: Bloomberg Press
• Year: 2012
• Print ISBN: 9781118409336
• eBook ISBN: 9781118410806
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

The dramatic and well chronicled crisis of 2007/8 marked a watershed moment for all stakeholders in global capital markets. In the aftermath, financial markets have become even more tightly coupled as correlations in returns across multiple asset classes have been at historically elevated levels. Investors and fund managers are, to a much larger degree than previously and often much more than they realize, subject to the risk of severe wealth destruction. The ultimate hazard, which is not adequately characterized by the widely touted notion of tail risk, is the systemic risk which arises when liquidity in markets completely evaporates.  Not only did this happen in the second half of 2008, but it has been repeated episodically since then – most notably in May 2010, in an incident known as the Flash Crash, and in the fall of 2011 when correlations were at historically elevated levels.

Conventional asset allocation tools and techniques have failed to keep apace with the changing financial landscape which has emerged since 2008. In addition to the preponderance of algorithmic trading and the associated changes in the liquidity characteristics of financial markets, a new paradigm of risk on/risk off asset allocation has emerged.  Risk on/risk off is a widely adopted style of trading and macro allocation strategy where positions are taken in several closely aligned asset classes depending on the prevailing sentiment or appetite for risk.  The consequences of the day to day (and intraday) switching between either a risk on or risk off tactical strategies poses significant new challenges to investors who are still making investment decisions with outmoded notions from traditional asset allocation theory.

How can one cushion the impact of systemically threatening events when the ability to exit financial instruments becomes almost non existent? How can one trust the integrity of financial models and orthodox macro financial theory which have become increasingly discredited? Can central bankers be relied upon to become the counter-parties of last resort and provide a safety net under the financial system?  These vital questions, and many others, need to be addressed by everyone who has a stake in modern financial markets, and they are addressed in Systemic Liquidity Risk and Bipolar Markets.

Proper functioning markets require fractiousness or divided opinion, and this needs to be lubricated by communications from central bankers, economic forecasters, corporate executives and so on. As long as such messages and market conditions remain ambiguous, providing asymmetric information to different market players, then the conditions are present to enable systemic liquidity to be preserved. Seen in this context the prevailing paradigm of bipolar risk on/risk off asset allocations is both a prerequisite to liquid markets, and also paradoxically, when one side of the polarity becomes too extreme, a major source of systemic instability.  Should such polarities become critically unbalanced, and should the signals received by market players become symmetrically disadvantageous as they were in the fall of 2008, then an even more substantial systemic liquidity crisis than that seen in those troubled times is a dangerous possibility. 

Apart from the practical risk management tools and tactics that are recommended in Systemic Liquidity Risk and Bipolar Markets, there is a provocative and cogent narrative to provide anxious and perplexed investors with a coherent explanation of the post GFC financial environment, and which should assist them in navigating the choppy waters ahead.

1

Introduction

The events of 2007/8 pulled back the magician’s curtains and revealed a rather shocking truth about the global financial system – markets can seize up and become completely illiquid. Although previous generations may have experienced similar episodes of systemic illiquidity, in the fall of 2008 the magnitude of the near meltdown came as a traumatic shock to most working in the financial world as well as those beyond. Even for assets such as short-term commercial paper and money market instruments, the liquidity which had been taken for granted completely evaporated. During Q4, 2008 the only asset class for which there was real liquidity was short-term government securities of very highly rated sovereigns. Banks did not want to deal with each other and most asset managers refused to purchase assets, where the risk of not knowing when they might be able to sell them again reflected a profound crisis in confidence regarding the efficacy of markets and the liquidity of market instruments.

At the limit there is ultimately a fundamental paradox regarding liquidity which is that when it is most required it is likely to be non-existent. John Maynard Keynes had a keen eye for noting paradoxes at the root of economic behavior, and made the following observation regarding what today would be called systemic liquidity. [1]

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.

To slightly paraphrase another of Keynes’s classic observations about markets, one could sum up the worst case scenario for the demand for liquidity in the following aphorism “When average opinion comes to believe that average opinion will decide to turn assets into cash, then liquidity may be confidently expected to go to zero.”

One of the central tasks of this book will be to explain [2] in as comprehensive and precise a fashion as possible the threat posed by critical financial episodes which can best be described as periods when there is a disappearance of systemic liquidity. As will become clearer, the notion of liquidity is one of the more elusive and poorly addressed concepts in the macro-economic and finance literature. Rather than assuming liquidity of markets as a given [3] a full blown account of systemic liquidity and the risks of its disappearance should be an indispensable component of any macro theory of financial economics. It is also imperative that there is recognition that we need to move beyond a view of the kind of liquidity crisis that may face an individual firm and realize that the much greater systemic threat is the kind of crisis – as seen in the second half of 2008 – where many if not most financial firms were, at the same time, confronting a liquidity crisis. One useful starting out definition for the risks posed by a systemic liquidity crisis is one proposed by the IMF in some useful analysis of the events of that troubled period. [4] “Systemic liquidity risk is the risk that multiple institutions may face simultaneous difficulties in rolling over their short-term debts or in obtaining new short-term funding through widespread dislocations of money and capital markets.” We shall return to the IMF study on systemic liquidity risk and other related analysis in later chapters and in particular in regard to the vital function of the money markets which is one of enabling maturity transformation. [5] If this ongoing facility is interrupted or breaks down there is a real risk of systemic meltdown and it will be suggested that rather than being complacent that the worst has already been seen with regard to the global financial crisis, there just might be an even bigger crisis on the horizon.

Although much of the focus in the literature on the global financial crisis is on the tumultuous events which took place in the second half of 2008 and especially in the wake of the collapse and bankruptcy of Lehman Brothers on September 15, 2008, the foreshocks of the crisis were being felt in 2007 especially during August of that year. August as a month has had a habit of producing nasty financial surprises – the LTCM crisis broke in August 1998 and it was a crisis in August 1971 that saw the US abandon gold convertibility for the US dollar [6] – and during August of 2007 there were some severe shocks to the financial system, the full implications of which would not be fully absorbed by the markets until one year later.

During August 2007, as the press release seen below indicates [7] even Goldman Sachs, which rarely acknowledges its own misfortunes, had to come to the rescue of one of its in-house hedge funds as a result of abnormal market conditions within the US markets during that time frame:

NEW YORK, August 13, 2007 – The Goldman Sachs Group, Inc. (NYSE: GS) today made the following statement: Many funds employing quantitative strategies are currently under pressure as recent conditions have resulted in significant market dislocation. Across most sectors, there has been an increase in overlapping trades, a surge in volatility and an increase in correlations. These factors have combined to challenge many of the trading algorithms used in quantitative strategies. We believe the current values that the market is assigning to the assets underlying various funds represent a discount that is not supported by the fundamentals.

The CFO of Goldman also made the comment that “Liquidity conditions were most extraordinary during early August (2007),” and then went on with the simple minded observation: “We were seeing things that were 25-standard deviation moves, several days in a row.” We shall return to this quotation again in what follows, but at this point we can just register the fact that invoking statistical assumptions based on a normal distribution to measure such disorderly behavior was to use a model that is not fit for purpose. [8]

Across the Atlantic during the same month another debacle was unfolding in what was yet another early warning of what was to come one year later. Although it was a relatively small mortgage lender the collapse of Northern Rock in the UK, with news footage of anxious depositors lined up outside the high street branches, is most definitely not the kind of image that bankers and policy makers like to see. The bank had to be taken over by the UK government due to its inability to fund itself in the money market. In a disingenuous comment, that would come to be echoed quite often since, the head of the British Bankers Association remarked to the media, while people were lining up outside the branches: [9]

“This isn’t about solvency, this is about a short-term problem that the Northern Rock has in getting liquidity – that is, getting some cash from the normal interbank lending market,” said Angela Knight, chief executive of the British Bankers’ Association.

“I think that anybody who is waking up this morning who is either a saver with Northern Rock or has got a mortgage … can be absolutely confident that they have got their money with or they have borrowed from a very sound financial institution,” she told the BBC.

Only the part in that statement that the depositors would be safe was accurate – the British government saw to that – but the institution was far from being sound or solvent as it soon transpired. Although the spokeswoman for the BBA had her own reasons for downplaying the magnitude of the Northern Rock episode, it is also worth recalling that in the summer of 2007 there was still a large degree of complacency on the part of central bankers and many policy makers with respect to the seriousness of the unfolding crisis in the financial system. By way of illustration the Deputy Governor of the Bank of England is on record in an interview with the Financial Times expressing the view that many key policy makers failed to recognize the gravity of the situation at the onset of the crisis: [10]

“I think it’s fair to say that in the early stages of the financial crisis most of us expected this to be a relatively short-lived seize-up in the financial markets; it would be over by Christmas, if you like. Whereas it was only gradually, over time, that we appreciated the full severity of what was occurring.”

The effort to explain the existence of abnormal market conditions which can give rise to bouts of extreme illiquidity will be a central theme of this book. Some other signposts to guide the reader as to the way things will proceed are that we will also need to examine such issues as the increasing sovereign debt risk, the possibility of a disintegration (even partial) of the Eurozone and the single currency, severe stresses in the European banking system, and numerous other wild cards that can contribute to a general discomforting sense that uncertainty and potential systemic risk, which have been very much in evidence since 2007, are not going to be ameliorated any time soon. Further themes which will be examined are the notions that price discovery, the primary function of markets, is being increasingly hampered, even distorted, by central bankers’ efforts with QE, in Europe by LTRO and the Outright Monetary Transactions (OMT) program announced by the ECB in September 2012, in FX markets by the very large footprint of the People’s Bank of China (PBOC) with more than $3 trillion of liquid reserves, and also by the aberrations which can and have arisen following the proliferation of algorithmic trading practices now omnipresent in many markets.

As the discussion proceeds it should become more apparent what the factors are, at the micro level of individual trades within a financial market, which are the principal determinants of liquidity and “price discovery.” In turn the dynamics and interplay of these various factors can then be used as heuristics for scaling up to a better understanding of the nature of systemic illiquidity events which are at the centre of the kinds of crisis episodes that have become more apparent since 2007/8.

Macro-economic theory is notoriously deficient in providing any real understanding of market liquidity, rather, as with so many other fundamental features of the contemporary financial economy, we are essentially told to take “liquidity” as a given. So one of the most crucial characteristics of the manner in which prices are determined, and the quality of trading activity which takes places in markets, as well as the nature of extreme price behavior which can arise from “an evaporation of liquidity” [11] remains as an unexplained article of faith. Surely one has grounds to be seriously troubled by the intellectual foundations for orthodox macro-economic theory which fails to account for liquidity, fails to explain how credit creation is a major dynamo for financial capitalism – a dynamo which has a proclivity for creating bubbles, and an absence of any tools which can anticipate when bubbles have gone too far and are about to burst.

What is the evidence of increasing abnormality in market prices over the past few years?

Figure 1.1, which comes from a presentation by the Bank of England’s Andrew Haldane who will appear again in this book, [12] is useful in illustrating the interdependency of market volatility and correlation, which are two good measures that can throw light on the observed increase in the propensity towards abnormal episodes in the financial markets in recent years. The chart plots the volatility of, and correlation between, the individual constituents of the S&P 500 from 1990 to 2010. In general terms, as shown over the 20-year period the relationship between volatility and correlation is positive which could suggest that higher volatility increases the degree of co-movement between stocks. But as Haldane points out, have we got the cause and effect the wrong way round?

Figure 1.1 Volatility and correlation of S&P 500 1990–2010

Source: Halda...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Foreword
• Chapter 1: Introduction
• Chapter 2: Cross-Sectional Asset Correlations
• Chapter 3: The Changing Character of Financial Markets
• Chapter 4: The Flash Crash
• Chapter 5: Detecting Mini Bubbles with the VPIN Metric
• Chapter 6: Foreign Exchange and the Carry Trade
• Chapter 7: The Enigmatic Performance of the Japanese Yen
• Chapter 8: The Aussie/Yen Connection
• Chapter 9: Precursors to Illiquidity
• Chapter 10: Mainstream Financial Economics Groping Towards a New Paradigm
• Chapter 11: Could a Eurozone Breakup Trigger Another Systemic Crisis?
• Chapter 12: China, Commodities, and the Global Growth Narrative
• Chapter 13: Drawdowns and Tail Risk Management
• Chapter 14: Liquidity and Maturity Transformation
• Chapter 15: Emotional Finance and Interval Confidence
• Chapter 16: Adjusting to More Correlated Financial Markets
• Appendix
• Index