Sporadic liquidity levels and trading volumes have meant positions are becoming increasingly difficult to get out of, head of EMEA trading for BNY Mellon Pershing, Mike Horan, told The TRADE.
It has become a self-fulfilling prophecy whereby people don’t enter positions to ensure they won’t be caught in them amid market volatility, Horan said – it’s wealth protection as opposed to wealth generation.
“We have conversations with clients on how something might be illiquid and it might be difficult to trade out of it. We don’t instigate those conversations but clients are being more open,” he said. “We’re not getting many clients enter into third line stocks anymore because they know themselves that if markets start to tank it’s going to be difficult to get out. Market makers don’t want to take positions in stocks when the market has been the way it has been.”
The inability for banks to commit capital along with changes to federal policy and interest rates in recent weeks have meant liquidity in the fixed income markets has become sparse and unpredictable.
“The fed has stopped buying bonds. Once they stop – roughly 100 to 120 billion dollars a month – and they let those positions mature then that’s impacting liquidity. From a liquidity perspective, the market has been on steroids,” said Horan. “Liquidity in less liquid bonds has been affected due to investor appetite for risk. Rates are going up and in that environment the less liquid stuff gets impacted as they’re seen as too risky.”
The perfect storm
For the equities markets, the stickiness of positions has meant new regulation such as CSDR has discouraged players from trading in less liquid stocks as they don’t want to be caught out by delays and subsequent fines.
“The penalty regime has impacted liquidity in less liquid stocks as no one wants to be late delivering these stocks and getting fined. Bilateral settled stocks have historically always been delivered late,” said Horan. “T 10, T 20. That’s the nature of the market. You do a trade OTC with a market maker and you’re going to have to wait quite a while for your stock to be delivered to you. The mandatory buy-ins have meant market makers aren’t putting up as much capital and they’re quoting wider prices. Liquidity suffers.”
The rise of passive funds has also damaged liquidity in third line stocks as indexes usually favour larger and more stable names that are guaranteed to pay dividends. As many passive funds are now benchmarked to the Closing Auction, increased use of algorithms which recreate the same trading patterns for certain stocks mean the Close has continued to grow.
“If you look at a volume curve of a standard stock, a lot has in the Closing Auction now. It’s a liquidity feedback loop. They’re fed data on how a stock usually trades. They create their own data and what you get is a lot more trading towards the start and end of the day. Electronic trading has been with us for so long that the algorithms have got smarter at the behest of humans. They’re feeding themselves,” said Horan.
“As banks have stepped out of capital commitment the void has been filled by systematic internalisers (SIs). A lot of the SI trades are not massive sizes. The problem is that in a falling market where you would have a human being putting up a price in size, the bots are more cautious than a human would be so they pull their liquidity away.
‘They’re a lot more responsive. It’s signal-based capital commitment. In the summer when there’s not much liquidity anyway, that’s made worse by volatility and by bots making prices and pulling out.”