Liquidity risks in markets are not intractable

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is group chief investment officer at Amundi

Financial markets promise to be one thing but often end up delivering something quite different.

When an asset is listed on a stock market it should be tradable without a discount. Prices of securities appear in real time on terminals but they are only valid if you can trade at them. Increasingly, you often cannot. 

The villain of the piece? Liquidity. Or rather the lack of it when you need it most. We are seeing liquidity “shocks” that are more powerful than before, and sharper. Amundi research has found the impact of trading $50mn of an equity, where that trade is within 10 per cent of the daily volume, has been doubling during episodes of stress since 2021 and quadrupled on certain days during the Covid pandemic.

The change is similar to hurricanes in the US — where the frequency is the same, but the force is greater — and damage correspondingly worse. Remember the UK gilt markets crisis in September 2022 when gilt yields moved from about 3.5 per cent a couple of days before the mini-budget to about 4.5 per cent two days later, a 28 per cent change in five days.

Or when the Japanese yen “carry” trade — borrowing in a low-interest-rate country to fund investment in assets elsewhere that offer higher returns — unwound in August 2024. The Nikkei 225 fell 19 per cent between July 31 to August 5 while the yen strengthened more than 7 per cent against the dollar in that period.

Added to this today’s investor must grapple with long-lasting crowded trades and momentum-driven investing at a scale we have never seen before. Those trades can disguise thin fundamental trading liquidity — either the trades are one way and you cannot find liquidity in a crisis, or it might seem there is plenty of liquidity but it is driven by momentum or quantitative driven investors and dries up when the market turns.

We are now at the stage where a portfolio manager must see liquidity as a dedicated fundamental of investing as they do credit risk, volatility or correlations. Sure, this adds complexity. But if they miss-estimate and mismanage liquidity on their portfolio, their investment performance could crater in 48 hours as they face investor redemptions while clutching insufficiently liquid holdings.

So far, so alarming. But it is not all bad. Extreme liquidity events, and the mispricings that come with them, bring opportunity to the active investor. A forced seller of an otherwise good asset is handing future value to the bold investor. 

Because liquidity shocks hit different types of investment unevenly investors can use them as a way of rebalancing their portfolios at a cost that, in normal times, would be prohibitive. Alternative investments in areas that can be tough to access, such as distressed debt or private equity, may become available on more attractive terms. In the same way discrepancies in asset pricing can arbitrage opportunities — to seek gains or lock in downside protection while most investors are looking the other way — become affordable.  

An important but less discussed effect of these sharp new liquidity shocks is how they weaken competitors by straining less-prepared investors.

It is now possible to be the better prepared investor. While liquidity risks are still underestimated and under-researched, liquidity is no longer intractable. With today’s big data tools, liquidity conditions can be anticipated, and actively managed. Models of future liquidity and trading costs can be built. These estimate the liquidity of each individual security by assigning bid/ask extremes. This gives the manager information on how much of the portfolio is saleable at acceptable cost. 

This modelling demands (very) big data sets and AI-type technology and the crunching of billions of data points and the running of complex simulations. No liquidity crisis is the same as another and bid/ask extremes vary from one security to another. Doing this is neither simple nor cheap, but it is effective and increasingly necessary given the way markets are evolving.

Historically this analysis was just not possible. The data wasn’t available, nor were the tools to predict what will happen liquidity-wise.

Investors who actively anticipate changes in liquidity may be accused of “reckless conservatism” looking for the worst-case scenario and allowing for it and in the process wrecking the prospect of a decent return. But efficient liquidity management is a source of returns as well as sound risk management. Fully analysed stress testing is a way to avoid being caught by surprise.

Inconsistent liquidity is damaging to investors. But the means to turn it to advantage exist. They just need to be adopted.