Market liquidity is something that many investors, especially individuals, either take for granted or rarely think about. They assume that when they want to buy or sell a stock, bond, exchange-traded fund or other publicly-listed security, they won’t have too much trouble executing the trade. Decades of advances in technology and the sophistication of market participants have cultivated a mindset where few seem to worry about the prospect that they won’t be able to do what they want (or need) to do, except amid the unusual conditions that prevailed during the global financial crisis or at certain rare times in the past.
Unfortunately, this view may be out of date. Changes in the regulatory landscape, a shift in investor preferences, an evolving market structure, the rise of high-frequency trading, and certain economic and geopolitical developments are undermining investors’ ability to easily buy and sell securities in a variety of markets. It is a situation that appears to be worsening rather than improving.
A changing regulatory landscape
Among the factors affecting market liquidity more recently is the Volker Rule, which, according to Investopedia, is “a federal regulation that prohibits banks from conducting certain investment activities with their own accounts, and limits their ownership of and relationship with hedge funds and private equity funds, also called covered funds.” Designed to reduce the risk that large financial institutions might (again) become involved in activities that played a key role in the 2007-2010 crisis, the change has also meant that markets now have fewer deep-pocketed “market-makers” who are willing to accommodate buyers and sellers at times when natural counterparties are unavailable. While large-scale speculation proved to be a major problem during upheavals, under normal conditions, it helps to stabilize markets.
A growing interest in exchange-traded fund investing has also undermined liquidity. According to the Investment Company Institute, aggregate ETF net assets were nearly $2 trillion at the end of 2014, more than eight times what they were 10 years earlier. The fact that investors of all shapes and sizes have accepted the notion that ETFs make it much easier to construct finely-tuned portfolios with customized exposure to a potentially broad range of sectors and asset classes has meant that fewer participants are active in the underlying instruments, making them more difficult to buy and sell. At the same time, ETF marketers, stockbrokers and others have been banging the drum about the ease with which such funds can be traded, leading many investors to ignore or downplay the risk that they might be difficult to acquire or sell at a time when many others might be doing the same.
Changes in market structure that were designed to make markets more efficient and, in theory, benefit investors have in many instances had the opposite effect. While the goal of allowing multiple trading arenas to compete with one another was to ensure that investors could direct their business to those which offered the best prices, things have not quite worked out as planned. Undoubtedly, specialists and others took advantage of investors when they had to send orders in New York Stock Exchange-listed stocks to that exchange, but buyers and sellers also benefited from having all orders go to one place. As trading venues have multiplied, it has fractured the liquidity that prevails when trading is centralized.
Ironically, conditions have also deteriorated amid the rise in high-frequency trading, which proponents maintained would actually improve liquidity. In reality, while methods and approaches vary, evidence suggests that many of these firms are more interested in using their high-powered technology to arbitrage inefficiencies among multiple exchanges and to front-run order flow than to assume the stabilizing role of being a market-maker. Aside from exacerbating moves up or down by “encouraging” investors to chase prices to get trades done, their presence has also led market participants to become more guarded about their intentions with regard to price and size, creating a level of uncertainty that is reflected in wider, less investor-friendly bid-ask spreads.
Another development that has affected liquidity in certain markets, especially the Treasury market, stems from the central bank interventions that have taken place as a result of quantitative easing. This policy, which was intended to force long-term yields lower, has created a situation where tradable supply has become severely limited, and where it has become harder for investors to buy and sell certain securities because they are largely under the control of the Federal Reserve. According to MarketWatch, “several years of asset purchases via the central bank’s quantitative easing strategy have ballooned [its] balance sheet to roughly $4.5 trillion,” with $2.6 trillion of that total in Treasurys.
End of the central bank ‘put’?
Finally, one factor that may have an even more dramatic impact on trading conditions is what appears to be an impending shift in U.S. monetary policy (which I discussed here and here). Over the past several years, investors have grown accustomed to taking on larger risks than they might otherwise have done at the prodding of the Fed, which has done its utmost to let investors know their interests were being looked after. This backstop of reassurance has been variously described as the “Greenspan put,” the “Bernanke put,” and more recently, the “Yellen put.” However, with the central bank apparently contemplating a return to “normalcy,” the result could be reduced risk-taking and more uncertainty about the future, further undermining liquidity.
In sum, while many portfolio managers might once have placed concerns about market liquidity far down the list of things that keep them awake at night, now might be the time for a rethink.