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We’ll start with the punchline: An imbalance has developed between the supply of and demand for liquidity, and as a result we’ve seen a significant increase in the potential for the public equity market to jump from a state of calm to one of chaos. Consequently, we tend to distrust situations where stability has become the consensus, as we believe any change in the narrative is apt to bring surprisingly drastic changes in the equilibrium.
The supply of market liquidity has been shrinking
The supply of liquidity in the equity market, as measured by the average size of the best bid and offer in the market, has declined precipitously. In the case of single stocks, liquidity has been declining pretty steadily for the past 10+ years, with some acceleration in early 2018 (top chart in Figure 1). Index-level liquidity, meanwhile, trended lower for a time and then took a big step down after February 2018 (bottom chart in Figure 1).
The step lower in liquidity in early 2018 wasn’t a coincidence. It coincided with “Volmageddon” — an equity market sell-off sparked by a surge in the CBOE Volatility Index (VIX) and the liquidation of some poorly constructed exchange-traded products. Along with the carnage in the market, this event caused significant losses for some market makers, which we think drove them to take a more conservative approach to their liquidity provision.
The liquidity supply is also more sensitive to the level of volatility
Figure 2 shows the same liquidity estimates for S&P 500 futures used in Figure 1, but organizes them by the level of the CBOE Volatility Index (VIX) at the time of observation. It isn’t surprising to see some drop off in liquidity as volatility rises, since market makers will tend to be more cautious when volatility and uncertainty rise. But this chart tells us that this relationship has been changing. For a given level of volatility, the average level of futures liquidity was significantly lower in the second half of the past decade than in the first half; the effect is particularly pronounced at higher levels of volatility.
We think this is a result of the growing role of systematically oriented trading firms in the market-making ecosystem. By some estimates, as much as 80% of equity market-making is now algorithmically driven. These firms recognize that the risk-adjusted returns to being providers of liquidity fall when volatility rises, leading them to rapidly withdraw their capital in such cases. Furthermore, because these firms tend to have less risk capital to work with than the dealers who used to dominate this space, they are highly sensitive to losses and their algorithms allow for missing out on potentially profitable but empirically more risky opportunities to provide liquidity.
Meanwhile, the demand for liquidity is increasingly volatility-driven
Over the past decade, there has been a proliferation of systematic strategies whose demand for equity exposure tends to move inversely with volatility. Volatility-target strategies, for example, aim to produce a fixed amount of realized volatility of return by dynamically adjusting their exposure to equities. They want to add equity exposure when market volatility is declining and reduce exposure when volatility is rising. Risk-parity and CTA/trend-following strategies can also exhibit this behavior.
Figure 3 shows that these strategies have been large sellers of equity exposure (blue line) when volatility rises (orange line) — for example, selling an estimated US$500 billion during the height of the COVID-driven volatility in March 2020. We believe this increased demand for liquidity just when supply is retreating has served to exacerbate recent market events, and we don’t expect this environment to change any time soon.
Why we’re skeptical about stability
Given the fragile liquidity equilibrium, we expect the market to be prone to moving dramatically from low volatility to high volatility, with the potential for that volatility to then de-escalate quickly once systematic strategies have reduced equity exposure. Figure 4 shows the rolling 24-month volatility of the one-month realized volatility of the S&P 500. The trend is pretty stunning, with the rate of change of volatility consistently two to three times what it was as recently as 10 years ago. It’s this degree of fragility that leads us to distrust situations where the consensus is for prolonged stability.
As we’ve noted, this is a trend that predates the pandemic, is likely with us for the longer term, and increases the potential for sharp and accelerating drawdowns. We think that understanding these dynamics will be critical for portfolio construction going forward, and that asset owners should understand their managers’ approach to this ongoing challenge, including their use of hedging strategies and their exposure to consensus views. Lastly, as colleagues on our Alternatives Team have noted, there may be a growing role in this environment for risk-mitigating strategies (e.g., market-neutral strategies) given the potential for more drawdowns, as well as for specialized strategies that can exploit these trends by distinguishing between winners and losers during liquidity-driven price dislocations.