In a year of central bank-spurred market fireworks, don't blame badliquidity for every ill.
Wall Street trading went from bad to worse this year due to the fact that there wasn't enough money on the market. Money managers were unable to buy and sell in size without moving prices because of the broken stock and bond markets.
There are violent swings in everything from Treasuries to small-caps.
In a year of chaos that has been the worst for 60/40 portfolios since the global financial crisis, it is not surprising that markets are cast as enemy number one.
The view of top traders is that tough investing conditions are par for the course as central bankers drain financial excess from every corner.
That doesn't mean that the plumbing in key markets isn't in need of fixing. Senior traders say that blaming the middleman for every ill over the past year is simplistic.
"There isn't anything systemically wrong in the markets and I don't think we have any threat to our existence," says the head of Europe, the Middle East and Africa electronic equities sales and coverage atBarclays. Things will improve when the macro backdrop improves.
There is a source of this information.
In their day-to-day lives, institutional pros are dealing with more arcane challenges. The stock market is getting crowded at the end of the day as index-tracking funds rebalance. US regulators propose reforms to the market structure that they say would boost transparency and competition due to the fact that retail trading is mostly benefiting firms such as Citadel Securities.
According to executives who spend their day on trading floors, there is a rundown of the big liquid debate.
According to research from the Federal Reserve Bank of New York, the bid-ask spreads on US Treasuries are still below their peak. The gauge of how much Treasury yields are deviating from a fair-value model has been on the rise.
The Treasury Secretary expressed her concern over the bond market. The New York Fed pointed out last month that market depth weakened in the two-year note as a reflection of uncertainty over monetary policy.
Banks have taken less bonds on their balance sheet because of tighter regulations. Darrell Duffie, a professor at theStanford Graduate School of Business, has worked with the Fed to study market liquidity.
At the same time, the Treasury market as a percentage of the US economy is larger than before the global financial crisis, and the central bank is no longer stopping private-sector buyers as it trims its balance sheet.
The market needs to handle more Treasuries with the same amount of intermediation capacity It's more difficult for the market to absorb that. It doesn't take much of a stress event to destroy the market.
The Fed research shows that poor liquidity in the five- and 10-year note is in line with the overall volatility of the market. The bond selloff has been easing recently, and other market participants say things are starting to improve.
Chris Woolley, director of trading at Man Group, said anything that is rate-sensitive has been difficult to trade. The top-of-book liquidity in bond futures is probably at its most recent lows, but I think it has slowed down.
The market is trying to find a solution to the bond-liquidity issue.
With banks taking on less risk, fixed-income investors are increasingly trading with each other in an arrangement that may eventually give rise to all-to-all trading, with platforms that give a broad array of participants the ability to transact.
Doug Longo is co-head of product specialists at Dimensional Fund Advisors, which has $540 billion in assets. We've moved a lot of trading to peer-to- peer networks because of that.
Portfolio trading, where investors can buy or sell bonds in a single transaction, is one of the hottest trends.
"You don't execute bond trades line by line anymore, that's an improvement, especially for institutional investors."
According to Coalition Greenwich, electronic trading of corporate securities will set a new record in 2022.
The average daily trading volume is in line with where it was in 2021. There's no liquidity in the market when asset managers design a strategy that doesn't work in all environments.
The S&P 500 Index's bid-ask spreads are not as high as they were during the 2020 selloff. Stock traders are surprisingly sanguine because of that.
"I don't think this year has been worse than other sell-off markets," said Inés de Trémiolles, head of trading at the $612 billion asset management company. I remember turbulent market times when a regime change happened. Monetary policy was going to change at some point.
It is not to say that things are going swimmingly. Hitesh Mittal is the former head of trading at quant firm AQR Capital Management and now runs the shop BestEx Research. Equity spreads are still adhering to their usual relationship with volatility, a sign that markets are not broken at their core.
When volatility is high,liquidity is supposed to be poorer.
As index managers track closing prices, quants obey volatility targets and market-makers hedge their exposures, a flurry of rules-based rebalancing and hedging is taking place near the close of a stock session. Fears are growing that the equity market is vulnerable to blow-ups.
The rise of passive investing has led to a similar situation in other asset classes.
All hands need to be on deck around the close for people who have less activity during their day. We don't have any type of operational incident around that time.
In Europe, as much as 25% of monthly on-venue stock volumes were executed at the closing auction in 2022, compared with less than 20% in the years before. In the US, similar dynamics can be seen. This has led to more funds being drawn to trade at the close on the basis of lower transaction costs. This isn't a good setup for funds that need to trade throughout the session.
Woolley at Man Group said, "We certainly need to be more thoughtful about how to make sure the funds can get access to the right liquid assets at the right time in the day."
Retail flows at Robinhood Markets Inc. are usually handled by a small group of market makers, such as Citadel Securities. These firms mostly execute these trades internally, meaning that the orders never end up on the open market. Individual investors aren't necessarily contributing to the overall liquidity of the market due to a large amount of stock dealing being conducted in private.
Retail speculation has waned somewhat, but 42% of stock trading volumes were executed off-exchange this year, compared with 37% five years ago. Questions are being raised about whether there's enough competition for these orders. The Securities and Exchange Commission is concerned about it. The proposed changes aim to direct more business to exchanges, while stopping short of banning payment-for-order-flow.
The head of trading at an $83 billion quant firm said that this is causing challenges for institutional managers. A lot of traders in general and institutions are moving to more schedule-based strategies which split orders up into smaller chunks over the course of the day. Blocks are being traded smaller throughout the day because of that.
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