The Run on the Shadow Liquidity System

Back in 2008 when banks and the like were busily going to zero the phrase that captured much of what was going on best was that it was a "run" on the shadow banking system. By that it was meant that, for the first time, the non-bank banks — sell-side firms, creators of CDOs, and the like — who were busily creating credit outside the traditional banking system finally had a run on them. Rather than, however, depositors en masse withdrawing their deposits, which is the way a run worked in traditional banking (or did until we had deposit insurance), the run on the shadow banking system involved the withdrawal of overnight funding via the repo market. The result, however, was the same, with shadow banks quickly having insolvency crises, with unhappy results for Lehman, Bear, and others that we all saw.

Something similar happened yesterday, albeit in the shadow liquidity system. As most will know, liquidity is, like so many things in financial life, something you can choke on as long as you don’t want any. So long as there is nothing awry in U.S. markets the depth of liquidity — the amount of stock, currency, futures, etc. you can trade without materially moving the price –  is impressive, almost certainly the best in the world.

That isn’t magic, of course. Liquidity is a function of various things working fairly smoothly together, including other investors, market-makers, and, yes, technical algorithms scraping fractions of pennies as things change hands. Together, all these actors create that liquidity that everyone wants, and, for the most part, that everyone takes for granted.

Largely unnoticed, however, at least among non-professional investors, the provision of liquidity has changed immensely in recent years. It is more fickle, less predictable, and more prone to disappearing suddenly, like snow sublimating straight to vapor during a spring heat wave. Why? Because traditional providers of liquidity, market-makers and other participants, are not standing so ready to make the other side of the market. There are fewer traders prepared to make a market for the sake of market health. This is partly because they can, but mostly trapdoorbecause of what has happened with high-frequency trading, algorithms, and the like, which increasingly jump into the trading queue in front of and around orders, creating some liquidity, but also peeling pennies for themselves, frustrating market participants and heretofore liquidity providers, but in the course of normal business generally accepted as a price that gets paid to the market’s battle bots.

But all of this changes market microstructure in insidiously destabilizing ways. For the first time we have large providers of this shadow liquidity, algorithms and high-frequency sorts, that individually account for large percentages of daily trading activity, and, at the same time, that can be turned off with a switch, or at an algorithmic whim. As a result, in market crises, when liquidity was always hardest to find, it now doesn’t just become hard to find, it disappears altogether, like water rushing out sight via a trapdoor to hell. Old-style market-makers are standing aside as panicky orders pour in, and they look straight at shadow liquidity providers and say, "No thanks. You battle bots take it". And, they don’t.