Skip to main content

Wild Ride on Wall Street: Early Test of Liquidity?

The stock market’s wild swing last week, including its sharpest sell-off since 2009, could provide an early indication of whether concerns about broader market liquidity declining are accurate, and if so, to what degree are financial regulatory reform or market evolution the cause.

Market liquidity is important because investors demand higher yields from illiquid assets thereby increasing the cost of raising capital, reducing investment and slowing economic growth. Liquid markets make it easier for firms to raise capital because investors are more willing to invest in companies when they can buy or sell shares easily. Conversely, illiquid markets make it harder for firms to raise capital because investors are cautious when they anticipate difficulty in accessing their investment.

It can be difficult to distinguish between price declines due to updated information, such as a poor earnings report, and price declines due to constrained liquidity—because in practice they often look similar. Most sell-offs strain liquidity as sellers are forced to accept steeper price cuts due to the lack of buyers. Price drops due only to temporary illiquidity are problematic because they do not reflect the market’s belief about underlying value. If broader market liquidity has declined, we would expect to see steep price movements, an unusually high ratio of price change to trade volume and higher volatility.

Market Liquidity, Corrections and Regulation

What is Liquidity?

Generally, liquidity refers to the ability of an investor to buy or sell an asset quickly and without significantly affecting the asset’s price. While there is no universally agreed upon definition of liquidity, a recent PricewaterhouseCoopers (PwC) study on global financial market liquidity divided the concept of liquidity into four elements:

  1. Immediacy: the time it takes to complete a transaction.
  2. Market depth and resilience: the relationship between the quantity of an asset bought or sold and its resulting price change.
  3. Market breadth: the ratio of assets advancing in price to those retreating in price.
  4. Tightness: the ratio of supply and demand where a lower ratio signals increased tightness.

The mechanics of liquidity are often spoken of in terms relating to water. There are pools of liquidity, where deep markets are those with large numbers of buyers and sellers and shallow markets refer to those with few. Like a pond where you can’t see the bottom, it can be difficult to know how deep a market is without jumping in. As a result, some markets may appear liquid until one tries to jump in. This is sometimes referred to as “illusory liquidity.”

Liquidity During Market Corrections

A market correction generally refers to a 10 percent decrease in the price of a stock, bond, commodity, or index. Corrections do not necessarily indicate the underlying value of individual stocks or bonds but rather refer to a broad decline of assets prices. Market corrections can lead to liquidity constraints because they are used as a technical boundary for investors and traders who sometimes react by accelerating sell-offs in the short term. This acceleration can cause liquidity conditions to deteriorate when sell orders significantly outnumber buy orders, decreasing tightness and breadth. To account for such an imbalance, sellers generally accept price cuts in order to find willing buyers, thereby reducing market depth.

Factors Potentially Affecting Liquidity

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) introduced a number of new provisions designed to remove risk from the banking system that impact liquidity. These include imposing increased capital reserves on financial institutions that could reduce their tradable assets. Dodd-Frank also sought to reduce proprietary trading at financial institutions through the so-called “Volcker Rule,” which some have argued limit the ability of those institutions to provide liquidity. As many of the regulations associated with Dodd-Frank are just being implemented, the recent market correction is an early test of any potential impact on liquidity.

In the aggregate, Dodd-Frank and its promulgating regulations attempt to promote the safety and stability of the financial system by subjecting financial institutions to enhanced supervision and regulation, requiring them to hold a higher percentage of high-quality, low-risk assets and limiting their ability to participate in high-risk trading. The PwC study argued that these regulations could reduce market liquidity. Federal Reserve Governor Lael Brainard, while speaking at BPC in June, was asked whether regulation was playing a role in reduced liquidity and answered: “is regulation playing a role? I would guess that it is.” However, others have argued that Dodd-Frank has not affected market liquidity, with most of the debate centering around the debt market, not the stock market.

Market liquidity measures may need to be adjusted due to structural changes in the market that have nothing to do with Dodd-Frank or financial regulation. These include a shift towards investments in exchange traded funds (ETFs) that aggregate baskets of securities into a single tradable asset. ETFs are designed to make it easier to for investors to diversify their holdings by allowing them to buy into entire indexes or sector funds with a single security. During this week’s swings, a computer glitch prevented firms from displaying ETF prices thereby restricting trading and liquidity. Changes intended to reduce swings in the market, such as the so-called “circuit breakers” introduced after the 2010 flash crash (another event that raised questions on liquidity) could also curb liquidity provision as they pause trading during large price swings. Any suspension of trading reduces liquidity by preventing the market from achieving equilibrium. Another unusual factor was the New York Stock Exchange’s decision to invoke Rule 48, a provision that speeds up market openings by suspending a requirement that stock prices be announced at market open during periods of large volatility. These factors and others may have played a role in changes to market liquidity.

Liquidity Concerns

Many policymakers have raised concerns about liquidity conditions regardless of whether they believe government actions have played any role in reducing liquidity. In its 2015 Annual Report, FSOC mentioned changes in financial market structure that could “impact the provision of liquidity and market functioning.” On June 8, Richard Berner, Director of the Office of Financial Research, mentioned that “liquidity appears to have become increasingly brittle, even in the world’s largest bond markets. Although liquidity in these markets looks adequate during normal conditions, it seems to disappear abruptly during episodes of market stress, contributing to disorderly price changes. In some markets, these episodes are occurring with greater frequency.” In its April 2015 Global Financial Stability Report, the International Monetary Fund predicted that as monetary policy normalizes post quantitative easing, it would reveal “a changed capital market landscape” where the “liquidity-inhibiting impact of regulatory changes, industry consolidation, and other secular factors will become more pronounced.”

Industry representatives have also raised concerns about liquidity. Earlier this month, the August issue of Goldman Sachs’ Top of the Mind stated that while “post-crisis financial reforms have reduced the likelihood of another banking-led crisis … they have also limited the amount of liquidity banks can offer clients.” Echoing that sentiment, PwC’s report looked into multiple metrics of liquidity and found that large trades have become harder to execute as banks have reduced trading asset holdings and market-making activity, reducing both risk and liquidity provision.

Liquidity is hard to measure because it is provided most when it is needed least. When market conditions are favorable, liquidity is abundant as investors bring money to the table. When market conditions deteriorate, liquidity declines as investors head for the exits. This is precisely why the current correction environment presents an opportunity to evaluate liquidity concerns.

If liquidity conditions deteriorate beyond historical norms, we should expect to see unusual levels of price volatility due to wider bid-ask spreads that cause smaller orders to have an outsized impact on the prices of liquidity constrained assets. Other indicators could include smaller orders due to an inability of markets to absorb large block orders or sellers deciding to sacrifice immediacy to make up for lack of market depth.

If no significant change in liquidity is found, it would be an indicator that post-crisis policy and structural changes have not had a major effect on liquidity during stressed periods in the stock market. If liquidity becomes unusually strained, it would indicate a change has occurred without indicating what the causes of that change are. Wall Street’s wild ride should serve as a reminder that markets are inherently prone to periods of instability. How well Dodd-Frank and financial regulatory reform have improved the financial stability of the regulated banking system is important, but is only one factor in addressing systemic risk.

Share
Read Next

Support Research Like This

With your support, BPC can continue to fund important research like this by combining the best ideas from both parties to promote health, security, and opportunity for all Americans.

Give Now