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How market liquidity causes price distortions

Liquidity is a critical force behind market price distortions (and related trading opportunities). First, the cost of trading in and out of a contract gives rise to a liquidity premium. Second, the risk that transaction costs will rise when market conditions necessitate trading commands a separate liquidity risk premium. Third, actual changes in liquidity can precipitate large price changes without any fundamental value consideration. Finally, low liquidity is conducive to ‘run equilibria`, where bids or offers of some institutional investors turn into pricing signals for others, giving rise to self-reinforcing dynamics with feedback loops and margin calls. Examples for liquidity-driven price distortions in the past include breakdowns of covered interest parity across currencies, bond market ‘tantrums’, and ‘fire sales’ in emerging local-currency markets.

The below is the second part of a series of updates of this site’s summary on market price distortions. The first part was on rebalancing and price distortions.

A reminder of the definition of price distortions

Price distortions are defined as deviations of quoted prices from a level that would clear the market if all participants were trading for conventional risk-return optimization. In principle, all flows distort transaction prices relative to contract value (view post here). However, mostly flow effects are small. Price distortion here means significant gaps between mark-to-market prices and a plausible range of economic values of a contract. Careful monitoring of distortion metrics is a key source of trading profits.

The various price effects of liquidity

Market liquidity here refers to the cost of buying and selling a security or derivative. It measures the efficiency of trading. Separately, market liquidity risk refers to the probability that trading costs surge when the need for trading becomes more urgent (view post here). Both liquidity and liquidity risk influence prices.

  • First, most institutional and private investors are willing to pay a premium on securities with high and reliable liquidity and require a discount on securities with low and uncertain liquidity (view post here). Illiquidity translates into higher transaction cost for a given trading pattern and eats into returns. The illiquidity risk premium is an excess return paid to investors for tying up capital. The premium compensates for the loss of flexibility to contain mark-to-market losses and to adjust positions to a changing environment.
  • Second, changes in liquidity or liquidity risk of a contract lead to a change in its price, irrespective of its expected discounted present value. For example, a rise in market illiquidity, which means a greater cost of trading, makes forward-looking investors require higher future yields on a security. Thus, uncertain and unstable liquidity conditions lend themselves to price distortions. Small shocks can produce large price moves and apparent dislocations.

Poor liquidity can also cause rational price distortions when market participants keenly observe each other’s positions and trading activity (view post here). For example, in OTC (over-the-counter or bilateral) markets lack of liquidity means that dealers do not much “buffer” flows and institutional investors effectively transact with each other. In this case, investors take each other’s bids and offers as signals and plausibly operate under the laws of game theory. In particular, when investors observe each other’s selling pressure they can rationally transact at prices below true value and give rise to so-called run equilibria, self-reinforcing price dynamics away from fundamental value.

There is evidence that liquidity as a price factor and source of price distortions has increased since the 2000s:

  • Regulatory tightening after the great financial crisis has reportedly discouraged risk warehousing of banks, which would make global liquidity more precarious (view posts here and here). For example, in the U.S. the Volcker Rule has banned proprietary trading of banks with access to official backstops.  Market making has become more onerous as restrictions and ambiguities of the rule make it harder for dealers to manage inventory and to absorb large volumes of client orders in times of distress (view post here).
  • By contrast, the role of institutional asset managers as liquidity providers has increased (view post here). Investment funds often buy and sell with the market, chasing return trends (view post here), due to redemptions and reliance on collateralized funding. Also, asset managers often engage in cash hoarding, which means that they sell more underlying assets in market downturns than is necessary to meet redemptions (view post here). This holds true particularly in markets with more precarious liquidity. On the whole, investment funds seem to make liquidity more pro-cyclical and may aggravate market price swings, thereby giving rise to upside price distortions in bull markets and downside price distortions in downturns.

Past experiences

In the 2010s there have been many examples of price distortions and trading opportunities that were shaped by liquidity conditions.

  • In developed foreign exchange markets liquidity shocks have been highly cross-correlated. In systemic crises FX liquidity shocks have formed negative feedback loops with funding constraints and volatility, leading to escalatory dynamics and fire sales (view post here). Even regular episodes of tightening dollar funding conditions have triggered one-sided flows in FX swap markets. FX swap markets serve as a conduit for secured dollar funding. Large one-sided flows can lead to a breakdown in the conventional non-arbitrage condition of the “covered interest parity”, leading to arbitrage or enhanced trading opportunities (view post here). Such opportunities can be measured by the “cross-currency basis” and have become common since the great financial crisis (view post here). Indeed, a new theory of risk-adjusted covered interest parity suggests that FX swap rates, i.e. the difference between FX spot and forward prices, deviate from risk-free interest rate differentials in accordance with the relative liquidity risk premia for the relevant currency areas (view post here).
  • The 2013 sell-off in the U.S. treasury market (“taper tantrum”) illustrated that dealers or intermediaries may reduce their own inventories and market making after risk shocks, thereby aggravating rather than buffering liquidity shocks (view post here). More generally, empirical research has shown that sudden large drawdowns in government bond markets are aggravated by poor liquidity (view post here). This tendency could increase over time, as a consequence of increased capital charges on market making, extended transparency rules for dealers, elevated assets under management in bond funds and the liquidity transformation functions of these bond funds (view post here).
  • Emerging markets appear to be particularly vulnerable to liquidity conditions Assets under management of dedicated EM funds have increased markedly since the 1990s. Trading flows have been highly correlated due to the usage of benchmarks, and EM asset prices and final investor flows tend to be pro-cyclical and mutually reinforcing (view post here). The discretionary decisions of fund managers seem to aggravate this pro-cyclicality: they usually increase cash holdings in times of market turmoil due to increased risk of future client redemptions(view post here). Local-currency emerging debt markets, in particular, have become more vulnerable to global liquidity and other market shocks, with foreign ownership being a key determinant of that vulnerability (view post here). As a consequence, global shocks can trigger sizable relative price distortions between markets and currencies that feature high foreign participation and those that are more isolated.



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