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Article / 02 April 2015 at 16:21 GMT

Postcards from the Edge: Liquidity, wherefore art thou?

Director / Accumen Management
United Kingdom
By Ken Veksler

The term "market structure" has been increasingly thrown around of late and it makes me wonder what that actually means. What is market structure?
I’ve been a participant in the financial markets for just over 20 years and in that time have been on both the buy and sell sides (the usual terms for being a buyer and/or seller of banking services). I’ve sold and I’ve bought not just services but also financial instruments for myself and also on behalf of others. And... after all that time and all those roles I will happily put my hand up and admit I’m not entirely sure what the heck market structure actually is.

In my first job as a strapper on an FX desk, my simple introduction to how markets worked was just this “You’re either a price maker or you’re a price taker” yelled at me by my boss and head of the desk.

That notion is simple and it works.

Of course, beyond that, you’ve got to think who constitutes the overall groups of price takers and makers, what do the intermediaries do (and who are they), where and how do the deals get done etc. Perhaps this is what is meant by the term market structure. All these players in their constituent parts are the very make up and hence structure of the market that we ourselves partake in daily.

The fact that I’ve not given much thought to the idea of market structure until recently perhaps says more about the efficiencies and efficacies of said market than it does about my own lack of idle curiosity. That very simple idiom of “if it ain’t broke, don’t fix it” most certainly applies here. Or it used to. For now, it is my belief, that this market is indeed broken. Or perhaps more to the point, the structure that it has now morphed into and the constituent parts of that very structure are no longer efficient nor effective in achieving its primary mandate.

Yes, I know, I can hear you as I type, you think I’m about to go into a rant about central bankers and how they’re the scourge of the Earth, laying waste to all in their path... Nope, not even close. I mean, naturally, yes, they too are part of this market, but I certainly wouldn’t hold them solely responsible or for that matter even largely so. They are but part of the broader issue. If I were to generalise (and lord knows I’m prone to it) I’d say the problem is liquidity and the lack thereof. Now, citing liquidity is a great catch all for those that don’t understand what it actually represents and how it comes to be in the first place. But it also serves to illustrate the point that without it the market fails to operate properly.

What constitutes liquidity is pretty simple, it’s the presence (uninterrupted) of buyers and sellers at all times and at all prices, meeting, agreeing their respective side of the transaction (price) and ultimately getting the deal done (transacting). If this simple mechanism breaks down or for whatever reason ceases to operate efficiently, then the entire market suffers the repercussions. Liquidity providers come in all shapes and sizes and obviously litter both the buy and sell sides (refer above) of the landscape. Naturally the bigger the participant the greater the propensity and willingness to transact on an uninterrupted basis. So, for instance on the sell side this invariably means tier 1 banks and the like. Your Goldman Sachs, JP Morgan, Deutsche et al. While conversely on the buy side it means the world’s largest hedge funds, corporate treasuries, pension funds etc.

Looking at the sell side firstly, until recently they’ve been able to operate fairly well, uninterrupted and unhindered. It may of course be argued (likely correctly) that this very operation unencumbered by sufficient oversight is exactly what led us down the rabbit hole of the GFC and into the global new normal as we now know it. In an attempt to right this egregious wrong they have had all manner of new regulation lumped upon them. 

The Basel III rules, Glass-Steagall and perhaps of most relevance finally, Dodd-Frank. It’s the last one that I believe has been the final nail in the coffin. While nowhere near entirely operational as it was originally intended, it has still had largely the required impact which has meant the substantial reduction of risk taking activities by deposit taking institutions.

Let me paint you a simple picture, in days gone by, the head of the FX desk in any one of these banks or chief EUR trader for instance, could walk into the office and fancy buying some. Once he’d bought some (say $30mio+), he could then turn around and buy some more (another $50mio+) and then just for a laugh after morning tea, perhaps he’d buy some more (another $20mio+). So all in, by the time he was ready to go to lunch, he’d be long of $100mio+ in EUR. In the process of having bought all that EUR, he would’ve been the catalyst for other counterparts in other banks to do likewise and then, they as pack leaders, would further be responsible for dragging the rest of the market in its entirety much higher with it. No rhyme, no reason other than the advantage of first mover etc.

Well, no more folks. Not at all. Intraday limits for bank traders have been so drastically cut, that they might as well punt margin FX at their local broker on a personal account, let alone be responsible for trading in such size as to actually swing the market around. I speak of course of those traders that still actually have a job in light of the sackings etc post the recent regulatory probes into price fixing etc. The point is, as liquidity and catalyst providers, that side of the equation is all but dead.

Naturally this is just an example as it relates to FX, but I can assure you a similar picture exists in many other markets and instruments...

On the buy side, it’s a similar yet slightly different story. Using hedge funds (and the larger ones at that) as the generalised protagonist here, the reason they were able to make such consistent outsized returns is because they were each in their own way niche players. Couple this “niche” expertise in certain market segments with the massive size to swing those very markets around and there you have the basic recipe to their success. Yes I know it’s very, very simplified, but that’s how I’m looking at it for now without writing you an entire white paper on how hedge funds make abnormal returns.

Anyway back to my main point, which is that as markets seemingly become more efficient and niches are prone to increased exploitation by new players entering the scene, the advantages that these players had continues to ebb ever so slowly away. So, if they were able to generate returns using a combination of size and niche expertise, then simply put, the niches are becoming increasingly “nichier” and the size they enjoyed throwing about so much, now leaves them as stranded as the proverbial beached whale. Meaning, that as they try and unwind positions in the face of a changing world, they end up doing more harm than good to their own p/l etc. So, as a result, the vast bulk of them are handing money back to investors as the world becomes a harder place for them to operate in etc.

And this too, draws liquidity out of the pool and leaves us with... yeah you guessed it....

My point to all of the above is pretty simple, the market as we now know it is so very vastly different to the market I once knew. It has been irreversibly changed and to such a degree that FX, for example, is now backed into a corner where no good can come from any of this.

Regulators are grinning, participants are shaking their heads and the market remains broken.

Erratic price action on the basis of what seems to be fresh air will not only continue but also actually amplify in its frequency and regularity. Activity as that witnessed in the aftermath of the most recent FOMC meeting which was entirely counterintuitive, or more to the point violently overdone, owes itself to the lack of liquidity and is soon to become par for the course rather than the exception.

Market structure? Yeah, it just ain't what it used to be.

– Edited by Clare MacCarthy

Ken Veksler is director of Accumen Management

benlouro benlouro
agree Ken once again. We just have to wait for the price of Money to go up around the world to see if things start to work again properly... have a good Easter.
goldfinger goldfinger
Interesting piece Ken. I am going back a long way but I worked for a bank whose mantra was that "we provide liquidity, much of the rest takes it". Needless to say they are currently going through the proverbial wringer!


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