By many measures, overall market liquidity has dramatically improved since the 1980s: as shown in the chart below, several technological and regulatory developments in financial markets have helped reduce trading costs, with the most notable transformation in recent history taking place when US exchanges reduced the tick size for stocks in the 1990’s and decimalization (tick size of 1 cent) was implemented on the NYSE in January 2001.
And yet ask any trader today just how much of an improvement there has been in liquidity and you will likely get punched in the face. Starting with the May 2010 “flash crash” and continuing to this day, market depth has become a joke, or rather a mirage, as none other than Goldman’s co-head of trading recently warned. Indeed, despite this “liquidity improvement” there were two “liquidity shocks” in 2018 (a “liquidity shock” is defined by detrending the illiquidity ratio versus its 3-year moving average given its strong autocorrelation). The 4Q 2018 liquidity shock, shown below, was the largest since 2011. Similarly, S&P 500 futures top-of-book depth reached its lowest level since 2008.
And, as we have discussed for much of the past decade, a big reason for this collapse in liquidity has been the transformation of the “market-making” topology, in which traditional providers of liquidity, those who actually took market-making, liquidity risk, were replaced with HFT algos who “add liquidity” but only if there is no stress in the marketplace; the moment a tremor, or worse a shock emerges, volatility vaporizes, leading to an increasingly unstable, fractured market which reprices violently and rapidly as Q4 2018 showed.
Amid this trader hellscape, in which any unexpected event can result in an instant flash crash, “a small band of humans is taking up arms against the rise of the machines” as Bloomberg puts it.
As Bloomberg reports, “fund managers who ride big sell-offs in stocks are relishing fresh Wall Street warnings that robots and the like are leaving the bull market more vulnerable to explosions in volatility and crashes in liquidity”, warnings such as this one we made ten years ago today with “The Incredibly Shrinking Market Liquidity, Or The Upcoming Black Swan Of Black Swans.”
It is this small group of rag-tag traders that are ready to pounce when, not if, the herd – from quants to passive money – is forced to unwind in a downturn just as the relative firepower of fundamental managers to buy the dip gets depleted.
According to Dominick Paoloni, the founder of IPS Strategic Capital, such a downturn is precisely what is coming: he believes that today’s equity rally is storing up all the ingredients for another flash crash. As a result, Paoloni started a fund three years ago to hedge price swings triggered by robotic programs going haywire (he is hardly alone in hedging for if not the end of the world, then at least the end of algo domination) and sees the current market calm prone to disruption.
Referring to a chart we have frequently shown, Paoloni said that “algorithmic trading strategies and other quantitative traders have caused exacerbated moves on both the up and downside in equity markets,” adding that “as AUM continues to flow out of actively-managed equity funds there are less participants available to bring markets back to equilibrium.”
The chart, of course, is this one:
To be sure, there is nothing particularly new about the thesis: while nobody cares when stocks rice, computers have long been a favorite scapegoat when stocks are falling and volatility edges higher (just ask Leon Cooperman). But the paranoia is in fact reserved in this case – as we explained a decade ago – and as last year’s sudden maelstrom and the ensuing melt-up demonstrated all too vividly.
Paoloni’s siren call was picked up half a world away over in London, where Richard Haworth also argues that algo traders are a destabilizing force. Similar to Universa Investments, his 36 South Capital Advisors offers protection against tail risks through long-dated out-of-the-money options on multiple asset classes.
“There’s an illusion of liquidity because the algos are active,” Haworth said in an interview in his Mayfair office, sounding suspiciously like this tinfoil conspiracy website. “But if they switch their machines off because they’re uncertain about some information that has come to light, that’s a lot less liquidity.” Go ahead, Richard, tell them the full truth: when the machines are switched off, there is no liquidity, and an order as small as a few thousands dollars can move the tick in the Emini.
Haworth’s paranoia was justified by a relatively recent JPMorgan research report that concluded index and ETF quants and options-related strategies dominate all but 10% of U.S. stock trading. The amount invested in large-cap equity funds tracking indexes recently eclipsed-cash in actively run funds of the same type, Bloomberg reported in February.
Put another way, there’s a vanishing cohort of human-powered funds with the conviction to snap up single-stock names in a falling market. They would act as a brake on losses.
Unless, of course, they too are swept away in the avalanche of selling which is sure to erupt should the Fed step away during the next market crash.
Back to Paoloni’s Absolute Return Strategy, it reminds us that a fat tail funds is a fat tail fund, the only difference is the timing – predictably, it focuses on the asset classes that have been most repressed by central bank micromanagement of markets, primarily equity-index options and VIX contracts. As one would expect, it’s had some of its best days when the S&P 500 plummeted by more than 4% in a single session. And while still a tiny speck compared to its behemoth passive peers, the $64 million fund is getting more inquiries of late from financial advisers wary of another 2009-style crash.
As one would also expect, the fund is eager to talk its book, and claims that the potential of a one-day decline of more than 5% has increased in recent years. This is absolutely true, however, it has also increased the odds of central bank intervention during every downtick, intervention which the following BofA chart confirms is precisely what has been taking place.
Of course, Paoloni’s aggressive stance is a lone voice in the wilderness: defenders – the vast majority of today’s traders who have never even seen a real bear market – of funds programmed to sell or buy on volatility triggers point out they are reducing spreads and day-to-day price swings in part thanks to their growing arsenal of assets. But the risk is that when volatility reawakens, they’ll exit the market on a dime and expose its fragility, says Paoloni.
“The illusion of a lot of liquidity dampens volatility. When that illusion is broken, volatility will be a lot higher than it otherwise would have been,” Haworth said.
And while he is right, so far he has been early. Hopefully, he won’t have long to wait for his thesis to come true.