The true source of liquidity in financial markets: Caveat Emptor column

Liquidity – its origins and effects – have long exercised investors, but one thing is certain: banks are not the main source of liquidity, despite what they would have us believe.

liquidity

When playing the card game Bridge, if all four players open with “No bid”, you get to throw in the cards and re-deal the hand. In the credit markets you don’t get that option. Fifty no bids later you are still long, watching the value of your position deteriorate.

If there is one thing that perplexes investors more than any other feature of the markets, it is how liquidity is never there when most needed. The events of the past few weeks have done nothing to change this fact.

The reason for the confusion is that few people have truly considered what liquidity is and where it comes from. Investors are not the only people who don’t appreciate the source of liquidity: most market-makers don’t either.

To start with, let us dispel the notion that market-makers make liquidity. If we go back in history, buyers and sellers of securities used to meet on the exchange floor, where a price was established at which both sides were happy to trade. The problem was that trading could only be done in one place, at one time and at one price. However, eventually brokers used their balance sheets to help customers trade, even if the other side of the transaction could not be found immediately.

Brokers made it their business to know where to find sellers to match their buyers and vice versa. Later on, to avoid a conflict of interests, broking and price-making functions were split on the exchanges and we ended up with the US specialists and the UK jobbers who made prices to all brokers.

All together now

Fast forward to May Day and the Big Bang and the separate factions were unified with brokers and market-makers, now called traders and salesmen, sitting on one floor and working for the same firm.

Fixed commissions were abolished and the firms lived by their wits and on the bid/ask spreads – along with any positive carry that might accrue to them from positions held overnight. The concept of price-makers and price-takers was born. As securities firms gradually got bought up by large banks, more capital was deployed and with that the size of the positions increased, as did the amount of risk taken by dealing houses.

Greater transparency within markets has come hand-in-hand with more readily available price information, creating a sense that where there are prices, there is liquidity. This is completely wrong. Although there has been a rise in the amount of aggregate risk market-makers can take, so-called price-makers are not the makers of liquidity.

Liquidity is made not by investment banks but by the collective power of global investors. Market-makers do nothing more than broke liquidity: they do not create it. In situations where markets begin to fall and there are more sellers than buyers, trading limits fill up quickly. If dealers have nowhere to go with their paper, liquidity evaporates. When investors stop buying, liquidity goes west, irrespective of what market-makers do.

It is demeaning for institutional portfolio managers to castigate market-makers when liquidity dries up: they should not expect dealers to commit self-immolation any more than they would themselves. The truth is that liquidity is a result of the interplay of buyers, sellers and brokers.

By their very nature, prices cannot drift higher. Prices drift lower until they find an end buyer. Once buyers outnumber sellers, prices rise again. Without buyers, the price can only fall. Although this appears axiomatic, the idea that investment banks can magically conjure up liquidity proves how this most simple of facts is either misunderstood or not considered.

The game of Bridge was given its name because it creates a bridge between partners. It all happens in code but it is clear to those who understand the rules of the game. If clearer communication existed between investors and dealers, many of the misunderstandings concerning liquidity could be dispelled and shocks could be reduced.

By Trojan Pony

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