| -- | May 10, 2018 The Liquidity Problem  Individual investors generally don’t think about liquidity. You send a market order for 200 shares of something, it gets filled instantaneously, no problem. Institutional investors have to think about liquidity a lot. Say you have 200,000 shares of a stock to sell that only trades, on average, a million shares a day. You have a problem. As a general rule, if you are more than 10% of the volume in a stock, you are going to have an impact on the price. You could spread the execution out over two days, but then you assume more price risk. In ye olde days, you could call up the equities floor at a bank and do a block trade in the third market, and transfer your risk immediately. But that doesn’t really exist anymore. You are kind of stuck putting it in the machine, and you are kind of stuck having a bunch of computers sniff out your order and trade ahead of it. The proponents of the computers say that they provide liquidity, which is partially true, and the detractors of the computers say they consume liquidity, which is also partially true. It is a complicated issue. Of course, there are all sorts of countermeasures and counter-countermeasures to this sort of thing, which has been the subject of a couple of books. The problem is that there is a lot less liquidity out there than there was six months ago, and there is really a lot less liquidity than there was 10+ years ago. We will explain why. Volatility and Interest Rates When volatility goes up, liquidity generally goes down. As you know, volatility has been higher, so liquidity has been lower. By the way, a good definition for liquidity is being able to transact at a price that is not disadvantageous—i.e., the price you see on the screen. Perhaps some of you have access to a futures terminal and have seen the order book for S&P 500 e-mini futures. You have probably seen that it is often less than 100 contracts per tick. If you go back to 2006, there were about 2,000 contracts per tick. Yes, liquidity is down over 90%. So, individual investors generally don’t think about liquidity, but they probably should. At ETF 20/20, we prefer funds with a lot of liquidity, although that is not always possible. This month, we’re adding a fund with low liquidity, but the reasons for its low liquidity are valid. Anyway, there is an axiom in markets: volatility and liquidity are inversely correlated. There is a second axiom in markets: as interest rates increase, volatility usually increases, too. The Fed has been withdrawing liquidity by hiking interest rates and conducting quantitative tightening. It’s not a coincidence that volatility exploded and liquidity disappeared. But there’s more to it than that. Index Arbitrage Index arbitrage is the act of trading small price discrepancies in stock index futures with the underlying stocks. In the old days, if you wanted to do this, you needed to carry a large balance of long stock, so you didn’t have to sell short on an uptick. Banks would generally carry a large short futures position, offset with a large long stock position, in order to facilitate this trade. This was known as carrying “balance sheet,” and banks used to carry a lot of it, because it was a profitable trade. The S&P futures roll was trading rich, so you could sell the roll at LIBOR + 25 and make additional profits if interest rates were going down.1 The act of trading index arbitrage provides liquidity—liquidity is posted in the futures contracts, as well as the stocks. Index arbitrage as we knew it has all but disappeared, because the Volcker Rule has done away with prop trading. Capital requirements also make it expensive to hold this balance sheet. Index arbitrage is now conducted by electronic trading firms, and nonbank broker-dealers, but most of that liquidity has disappeared. And a lot of it is because of regulations. People have a general idea that Dodd-Frank has contributed to a lack of liquidity in financial markets. If only they knew how big the problem is! No liquidity means being unable to transfer risk, as well as increased costs for investors. And not just institutional investors. If XYZ mutual fund has more impact on its trades, XYZ mutual fund isn’t the one that suffers. It’s you, the shareholder, in the form of diminished returns. There is a lot of attention paid to mutual fund fees, but people should perhaps pay more attention to execution costs—that is where the big savings are. I’m also a fan of increased tick size—go back to fractions in the stock market and you will see many of these problems disappear. If you look at charts of stock market volume, you will see that today’s volumes roughly correspond to mid-1990s levels. I would not consider that to be progress. And I would not consider the mid-2000s levels of volume to be an aberration—that’s what we should strive for in financial markets. We should incentivize people to post liquidity—not to consume it.  Hey, tonight’s the night—if you’re in New York City, come on out to The Daily Dirtnap party at Hotel Chantelle, at 92 Ludlow Street in the Lower East Side. It’s going to be amazing. Here’s the link for tickets, but you can also buy at the door. And one final thing—The 10th Man will be off next week. See you in two weeks.
__________
1 I know this is confusing, but bear with me. 
Jared Dillian
Editor, The 10th Man
 | Get Thought-Provoking Contrarian Insights from Jared Dillian
Meet Jared Dillian, former Wall Street trader, fearless contrarian, and maybe the most original investment analyst and writer today. His weekly newsletter, The 10th Man, will not just make you a better investor—it's also truly addictive. Get it free in your inbox every Thursday. |
Jared's premium investment service, Street Freak, is available now. Click here for our introductory offer. Jared Dillian, former head of ETF Trading at one of the biggest Wall Street firms and author of the highly acclaimed books, Street Freak: Money and Madness at Lehman Brothers , and All the Evil of This World , shows you how to pick and trade trends, and master your inner instincts. Learn how to use “Angry Analytics” as a leading indicator of budding trends you can profit from… and how to view any market situation through the lens of a trader. Jared’s keen insight into market psychology combined with an edgy, provocative voice make Street Freak an investment advisory like no other. Follow Jared on Twitter at @dailydirtnap. Share Your Thoughts on This Article
 http://www.mauldineconomics.com/members
Use of this content, the Mauldin Economics website, and related sites and applications is provided under the Mauldin Economics Terms & Conditions of Use. Unauthorized Disclosure Prohibited The information provided in this publication is private, privileged, and confidential information, licensed for your sole individual use as a subscriber. Mauldin Economics reserves all rights to the content of this publication and related materials. Forwarding, copying, disseminating, or distributing this report in whole or in part, including substantial quotation of any portion the publication or any release of specific investment recommendations, is strictly prohibited.
Participation in such activity is grounds for immediate termination of all subscriptions of registered subscribers deemed to be involved at Mauldin Economics’ sole discretion, may violate the copyright laws of the United States, and may subject the violator to legal prosecution. Mauldin Economics reserves the right to monitor the use of this publication without disclosure by any electronic means it deems necessary and may change those means without notice at any time. If you have received this publication and are not the intended subscriber, please contact service@mauldineconomics.com. Disclaimers The Mauldin Economics website, Yield Shark, Thoughts from the Frontline, Patrick Cox’s Tech Digest, Outside the Box, Over My Shoulder, World Money Analyst, Street Freak, ETF 20/20, Just One Trade, Transformational Technology Alert, Rational Bear, The 10th Man, Connecting the Dots, This Week in Geopolitics, Stray Reflections, and Conversations are published by Mauldin Economics, LLC. Information contained in such publications is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The information contained in such publications is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. The information in such publications may become outdated and there is no obligation to update any such information. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.
John Mauldin, Mauldin Economics, LLC and other entities in which he has an interest, employees, officers, family, and associates may from time to time have positions in the securities or commodities covered in these publications or web site. Corporate policies are in effect that attempt to avoid potential conflicts of interest and resolve conflicts of interest that do arise in a timely fashion.
Mauldin Economics, LLC reserves the right to cancel any subscription at any time, and if it does so it will promptly refund to the subscriber the amount of the subscription payment previously received relating to the remaining subscription period. Cancellation of a subscription may result from any unauthorized use or reproduction or rebroadcast of any Mauldin Economics publication or website, any infringement or misappropriation of Mauldin Economics, LLC’s proprietary rights, or any other reason determined in the sole discretion of Mauldin Economics, LLC. Affiliate Notice Mauldin Economics has affiliate agreements in place that may include fee sharing. If you have a website or newsletter and would like to be considered for inclusion in the Mauldin Economics affiliate program, please go to http://affiliates.ggcpublishing.com/. Likewise, from time to time Mauldin Economics may engage in affiliate programs offered by other companies, though corporate policy firmly dictates that such agreements will have no influence on any product or service recommendations, nor alter the pricing that would otherwise be available in absence of such an agreement. As always, it is important that you do your own due diligence before transacting any business with any firm, for any product or service. © Copyright 2018 Mauldin Economics | -- |
