The Biggest Risk to the Stock Market ? The Illusion of Liquidity ?

lets reflect for a moment on the subprime mortgage meltdown.  Why did all those banks give loans to anyone with a pulse and why did institutions buy those loans ? Because the spreadsheets told them it was ok.  Their models included “no way it will get this bad” default rates. Which was great, until it got that bad and then some.
Now lets look at the stock market. Today’s models include variables based on liquidity.  Every high volume trader only has a single exit strategy: Sell the stock (or some synthetic version of selling the stock).  Every one of their models is based on the fact that the liquidity will be there.
What happens if its not ?  What happens if the volume introduced by High Frequency traders disappears, or as some suggested about yesterday, they just decide to stop trading ?
Where will the buyers come from ?
The stock market ecosystem has changed considerably in the last 5 years. The interdependencies have changed and expanded.  Not only do we live in a global economy, we transact on a global network.  But these interdependencies have a significant problem, you don’t know when a node/trader disconnects until its too late.
If a fund/institution/High Frequency Trader generates 100mm shares or contracts a day/week/month, market observers will tell you thats a great thing because it creates a liquidity premium. In other words, because there is always someone on the other side of a trade, it is easier to match buyers and sellers and that ease creates smaller spreads and often lower pricing.  On the surface thats a great thing.
It is a great thing until the market becomes completely dependent on that liquidity.  If every model expects X volume, what happens when that volume falls ?
Now some may say that the risk of light volume is just the risk of playing the game, and they are right.  But it also opens the door for market manipulation. You have heard of “too big to fail”.   What do you call it when a significant percentage of  volume of an exchange is concentrated in just a few hands ? Too big to pull the chair ?
You pull the chair when someone expects to sit comfortably on a chair, the chair is yanked away  and that person lands on their ass. You pull your trading volume when the market expects it to be there and what happens ? There can be a lack of buyers, which in turn pushes stock prices lower, perhaps quickly and significantly. Which could lead to triggering selling programs, pushing the market down to circuit breaker levels.
What is to prevent growth of a few high volume traders or consolidation of those players to put themselves in the position (if they are not already), to do a planned “pull the chair ” on the market ?
Why wouldn’t they build dependencies on their volumes and then on a low volume day, or on a day where there is news that could be seen as a catalyst to the down side, just stop trading? Knowing that in minutes, prices would fall.  A decline they would be expecting. A decline they would take advantage of, buying or trading on the reduced prices.  Or it could happen in reverse. They could pull the chair and short stocks that rose because there were natural sellers and walked away.
Of course there would still be huge risk to this practice. But that just exasperates the systemic risk to the market.  If the high volume trader thought this practice could make them huge money, it could wipe them out if it didn’t work.
Tell me why it couldn’t or hasn’t happened ?
Now as far as my portfolio is concerned, thats not a bad thing. I tend to be an investor that is a shareholder,  with much of my portfolio paying me cash. If the market craters like it did yesterday, it is always a buying opportunity. I’m don’t freak out about where my portfolio is marked to on a daily basis. I look for opportunities to increase my ownership or increase my cash returns. Which i did yesterday. But I dont think its good for the overall market. I don’t think its good for our economy. I don’t think its good for the general well being of the country and the world.
So what can be done ?
To me its pretty straightforward. Regulating agencies should set a trading volume threshold relative to exchange/issue/security volume that when exceeded, the trading entity must “notify” the appropriate agency . In the event they plan to vary their trading below or above that threshold, they must immediately report the change to the regulating agency. The agency won’t report to the public the change is coming, that would not be fair. However, they will be able to notify  the exchanges to expect trading volume changes .  This will allow them to coordinate actions among the exchanges . Something that did not happen yesterday , but needs to happen in the future.
The illusion of liquidity and the de-levaraging that occurs when markets lose significant amounts of liquidity is a real risk that we need to acknowledge before something really bad happens
One last thing. I’m not suggesting I have all the answers. I certainly do not. But I do think it is valuable to throw ideas out for discussion.  These posts on the market are food for thought.
If I think I have the definitive answer, I’m not shy. I will say so 🙂

20 thoughts on “The Biggest Risk to the Stock Market ? The Illusion of Liquidity ?

  1. A few points first it wasnt the computers models that were the reason for all the poor mortgages/loans, it is and continues to be the incentive structure at the banks/mortgage shops. If you are putting up the numbers during a given year you will be paid a sizable bonus at year end regardless of whether the loan turns out to be profitable to the bank down the road. This creates an atmosphere where all the commercial lenders, mortgage lenders, business bankers, and private bankers want to jam credit down everyones throats because they know at fiscal year end they will be rewarded whether the loan is ultimately profitable to the Bank…this needs to change.

    Second I am not sure the gripe about the HFT you are providing if you are long term who cares if traders are scraping pennies back and forth off one another. Did the value of Proctor truely drop 35% during the crash because their were no bids in the market? I think a crash like we had was actually good for the markets…too many johnny come latelys were jumping into the market on margin thinking yet again stocks could only go up. I would love for the traders to pull the chair on the markets as any prudent long term investor should who invests for cash flows, it is ironic though how noone was complaining on the low volume ramp of the past year but the market after rising from 6500 to 11200 gives back a mere 1000-1500 points and everyone is crying foul. I have never seen manipulation in the market as I had seen during the last year with massive short squeezes in stocks being triggered by many of the large brokers, however, noone seems to mind.

    Comment by esebille -

  2. This kind of punctuates the need for NYSE specialists. While they are outdated, if they wanted a franchise to rip guys off for quarters and eighths on normal days, they had to stand there on days like yesterday and make a market no matter what.

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    Comment by Admin -

  3. I agree with poster before me… the taxpayer got hit with all the subprime mortgages… I can’t agree with that statement more.

    I don’t think they could simply “pull the chair” although if they have the ability to, I’m sure they will. It would be difficult to time that right and create the desired effect.

    Comment by jamakmfg -

  4. Pingback: Market Crash and Rebound: HFT Problems, Audio of Crash, Where Things Stand, David Kotok and Art Cashin, Paul Kedrosky, Mark Cuban, Kid Dynamite, 60% Robots | N2PQ Mortgage News and Information Network

  5. Yep every player in the subprime mortgage meltdown was allowed to pass the buck until it stopped at the taxpayer.

    Liquidity fueled the meltdown. Wall Street created the liquidity. This led to outrageous behavior of banks, homeowners, mortgage companies, institutions, etc. It was really a big pyramid scheme. They knew if they took these loans off the books of banks then banks could make more loans which would would then spur housing demand and lessen supply which means the prices of these re-packaged mortgages would go up. They rode it as long as they could and then bet against it at the end when the walls came crumbling down to hedge their losses as much as possible.

    Now this notion of what if one very large entity could suddenly stop trading which would drop volume doesn’t matter if you’re actually investing and not gambling.

    Comment by trip1ex -

  6. “lets reflect for a moment on the subprime mortgage meltdown. Why did all those banks give loans to anyone with a pulse and why did institutions buy those loans ? Because the spreadsheets told them it was ok. Their models included “no way it will get this bad” default rates. Which was great, until it got that bad and then some.”

    That and the fact that the GSE’s were and continue to essentially guarantee these loans for the too big to fail institutions that are carrying them on their balance sheets.

    Comment by jds430 -

  7. Fantastic point Mark. I wanted to share a couple thoughts.

    First, most of the mortgages were made to anyone with a pulse because banks did not have to hold the mortgages. They essentially played financial hot potato by making bad loans and packaging those loans to get them off their books to then borrow more and lend more and leverage up to get a return that is higher than what a bank can make just lending as it should. (sorry about the run-on sentence)

    Second, one of the major problems that has not been acknowledged by most media and by any politicians is that our regulating agencies did NOT regulate as they should have. They have been ineffective for quite sometime. So merely creating a regulating body is not a solution in any bill. Making them accountable just as executives are (or were in 2000) by sending them to jail if their agency does not do a good job would solve this.

    Speaking of which, why haven’t any CEOs gone to jail yet? In 2001 at least a handful went to jail. In this instance many bad CEOs have destroyed a MULTIPLE of wealth as was destroyed in 2000.

    Comment by disfiguredskating -

  8. I still believe in the market and if we can get back to constitutional basics, I still believe in America. I’m not for total deregulation of everything—yes, fair rules for Wall Street AND Main Street have to be implemented and more importantly, enforced before new laws are written. I believe Government should fear or at least respect the citizens—and not vice-versa. Government needs to be small but tough—tough when they need to be and out of the way at all other times. Turn loose the few rainmakers like Mark Cuban and the many ambitious and motivated wage earners to work for people like Cuban—and this country is still the best place to be for all types of creative innovations to lead the world. Our original formula was amazingly simple and the results were simply amazing. It’s not too late to get our groove back. Is this off topic? Only slightly. Those manipulating the market will end up being manipulated themselves when the next big wave hits—the next batch of brilliant achievers leading public companies that kick ass.

    Comment by dcangelo -

  9. The panic selling that we saw is normal in extremely over-extended markets (1987, 2010): all buyers are invested, prices are ahead of fundamentals/reality, and all it takes is some bad news (Greece in this case) for bids to dry up. Market makers routinely step aside when markets are in a free fall. So do HF trading systems. They know that catching a falling knife is a good way to get killed. Just wait for the order book to be cleared and all stops to be taken out, then buy at the lows. They provide liquidity when it suits them. This is not speculation, WSJ and others reported that this in fact happened last Thu. Sorry, but no amount of regulation is really going to create a fair marketplace for retail investors. Pros will continue playing these games until laws are made and enforced (and then they’ll just exploit the next loophole). Only way to win is to invest as Mark does (rely on cash flow from dividends and have the temperament and firing power to stay the course for as long as it takes to get a fair price), or hedge your bets (options, long/short).

    Comment by verdacity -

  10. Too much power in too few hands? Yes.

    But before proposing more regulation, how about asking how the power got there?


    The only solution that will avoid massive fraud masquerading as an investment market is to abolish the SEC.

    If the SEC had not been created, nobody would trust their money to strangers. Investment would be made directly into small businesses and our economy would be flourishing in ways we cannot even comprehend.

    Comment by Jeff Nabers -

  11. It used to be simpler: Investors would research companies and for those companies that showed promise—the investors would decide if the price per share was a good deal. Or, investors would decide if an IPO showed enough potential to justify the asking price. Or, as Mark pointed out in the second to last paragraph, if they paid a dividend, were they worth owning for that reason. It’s not easy stuff, but it is simple stuff. But now, the universe has changed. It might have nothing to do with how good or bad a company is or who leads the company, how they are managed, etc. Now, it’s about strategies to manipulate the market. This leaves small investors like me at a major disadvantage. That said, I’m not sure incompetent oversight is a good answer either. Punitive rules will stall our ability to invest for income, not assist it. This is one of those awful situations where there might not be a right answer—just a few wrong ones.

    Comment by dcangelo -

  12. I really think there should be a limit not only on volume but
    really on spec.
    spec should be forbidden.

    Markets are supposed to funds economies not
    the reverse.
    Only investment volume will makes a sense in linking a price
    to some kind of business related valuation.
    Spec volume is not for real.
    That false idea of liquidity, it is never more
    obvious than when the market trades a price on low volume
    or high spec volume: that’s not value, it’s just price.

    we should revisit he usefulness of these market and banking structure.
    the minute markets and banks start costing a dime to the ecenomy
    is the time to start seriously considering closing that down
    and rebuild a financing system that finances the economy.

    Comment by livemamad -

  13. This kind of punctuates the need for NYSE specialists. While they are outdated, if they wanted a franchise to rip guys off for quarters and eighths on normal days, they had to stand there on days like yesterday and make a market no matter what.

    This is the thing that gets my goat when the ‘high-frequency traders provide liquidity’ argument is used. They only provide it when it’s in their favor, and are free to walk when things go bad.

    One way to fix it would be to say to firms that are co-locating their boxes inside the exchanges data centers… “If you guys want the first millisecond peek at the quote stream, you have to post a two-sided market all the time”

    Comment by fearsomefinance -

  14. Why not just use limit orders so that you don’t accidentally sell a $40 stock (seconds ago) for $0.40 because the volume evaporated?

    Traders need to take responsibility and not assume the market makers will be there to give them a good price. Set a limit.

    Comment by scottjad -

  15. it all stems from monetary policy. too much money is created, and as all money is loaned into existence in our current system, this also means too much debt is created. over time, hell ensues (i.e. debt crises, excessive leverage in markets, excessive speculation due to excessive money being created, excess money going to banks who then lobby for unfair control of govt, etc)

    to fix the economy, fixing monetary policy (i.e. the federal reserve system) is necessary. a review of the constitution and its origins may be appropriate here; thomas jefferson and andrew jackson basically dedicated their life towards preventing this type of economic destruction, because they lived under the same thing when the colonies were subject to the monetary policy of king george and the british empire. alas, when history is forgotten, its repeat is inevitable.

    Comment by kidmercury -

  16. First, it was during the Carter administration in 1977 that The Community Reinvestment Act was passed prohibiting lending institutions from the practice of “redlining” various areas and basically not lending in those areas. Why did they do that? Because the numbers were not right and these institutions believed in the old free market adage of—-of, MAKING MONEY.

    This was the most important salvo fired at the free markets. The result was years and years of finding ways to “hide bad loans” in various financial instruments. Finally, the stupid practice came to a complete “head” in 2008 creating the most unnecessary market crash in our history. The cause was simply: the government telling free markets how to behave.

    Today, we find our government involved directly with the financial “big-boys” and the regulators failure to properly supervise these giant market makers.

    Also, with the advent of computers and the abundance of “on-line” traders and the auto trade orders, we have a prescription for market disruption that is both unprecedented and unnecessary.

    Comment by estateman -

  17. Yeah,I don’t claim to understand everything Mark says either.

    But what I do know is this.Mark says some vital “stuff” for
    the Wall Street types to heed.We’re heading down a slippery
    slope,and if we don’t watch it even the feds will be scratching
    their heads trying to get us out of it,then tax main street

    But regulating agencies won’t tell the public everything
    anyway.But for most of us putting your money in CDS,basic
    bank accounts and starting a small business with money
    you can afford to spend,is where its at to make money.

    Not the stock market.

    Comment by mdgrove500 -

  18. The high frequency traders look for high volatility to make money. Though i think they never anticipated a crash like yesterday. On other “Normal” high volatility days those guys make tons of money in a single day. The calm days present them less opportunities to make money as there are less people buying/selling and thus lesser pricing inefficiencies in the market.

    Comment by snahar -

  19. I agree with everything here except for the first paragraph. The reason anyone could get a loan is because ratings agencies did not do their job. No one from the ratings agencies actually knew what was in the mortgage backed securities and didn’t do the proper research to rate them correctly plus since the banks are their paying customers they really didn’t want to find out.

    Comment by sportsblognet -

  20. I won’t pretend to fully understand this entire subject and everything discussed in the comments section of Mark’s previous post, but I do know that change is needed and fixes need to be put in place to stop the maniupulation of markets. Too much power is in the hands of way to few people / organizations. As an “average Joe” that has to invest in the markets to ensure some kind of decent retirement, the fact that large players can manipulate markets at will scares the hell of me.

    Comment by dobieo -

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