From a Deafening Roar to Silence in a Moment: Systemic Liquidity Risk

Human traders make decisions all the time. They use buy and sell stops, using automation to assist in their execution. But there's though behind these moves, and they can be changed and update constantly.

Trading algorithms simply execute their programs. And they account for most of the trading volume on any given day. Many are written to exploit the same trends and thinking. One of which is "If the market suddenly falls off a cliff, get out, immediately, and don't come back until things are calm."

But with every program that executes this commands, more selling hits the market, and the crisis worsens. Until, theoretically, all the machines leave at once, waiting for others to come back in and restore equilibrium, which none of them are programmed or prepared to do. What then? Will human traders have enough capital or temerity to step back into a market that resembles a black hole for capital?

Since February's flash crash, Goldman Sachs' head of Global Credit Strategy, Charles Himmelberg, has again and again sounded the alarm that the algorithmic transformation of markets means liquidity, not leverage, should be the preeminent, catalytic concern as quantitative tightening progresses and volatility returns.

"I routinely field questions from clients asking where the risks are building up, and this is the one I worry about," he told The FT earlier this month. "Financial markets have changed pretty dramatically since the crisis."

We keep coming back to liquidity as the key threat — if a market shock causes algorithmic strategies to simultaneously unwind or the passive herd to flee, supply could rapidly overwhelm demand, causing widespread panic.

Now, mounting evidence suggests the threat is intensifying. Speaking to The Wall Street Journal, Jeffrey Cleveland, chief economist at Payden & Rygel, put current market liquidity in stark terms: "It's like going into a grocery store and there's nothing on the shelves."

Some analysts and investors said markets that may seem superficially more efficient were more prone to "liquidity crises", where waves of sellers suddenly overwhelmed the depleted capacity of market-makers such as banks to absorb and intermediate the buy and sell orders.