“The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”
–That’s the statement the Greenspan Fed used to steady the markets after the 1987 Crash.
I personally get turned off when news outlets all jump on the same topic and beat it to death. So, I am NOT going to talk about Bruce Jenner in this post. However, I am going to make a couple of points about a topic that has been getting a LOT more press recently: LIQUIDITY. Having grown up on the Chicago trading floors, I am not going to talk about it in esoteric terms, I’m just going to write a few impressions about the way it used to be. There have been a lot of articles written recently about the possibility that markets seize up without the lubricant of liquidity. Some might blame the regulatory environment for making banks shy away from a traditional role, some might point to the rise of algorithmic trading, while others might lodge concerns about the heavy hand of central bank intervention in bond markets. While this may not exactly be an ‘actionable’ post, I personally believe there’s more than a loose link between liquidity and implied volatility.
Trading Floor Perspective
So, let me take you back to how the trading floors actually functioned. In the trading pits, order filling brokers always stood in the same physical spot. Big locals (or market makers) stood in close (very close) proximity to big order fillers. Same guys, each and every day. Back in the late 1980’s, when the t-bond pit was what I naively considered to be the center of the financial trading universe, on the “top step” there would be big locals and big brokers right next to each other. If a big local took a break, another smaller guy could take his place while he was gone, but was expected to step down on return. These guys earned their positions. There were no headsets into the pits in those days. The orders that came into the pit for execution from the desk brokers on the phones were all dependent on a direct line of sight. Orders came in over the phone…not on instant messenger. It was all physical and personal.
So what happens in a busy market when a filling broker would get an order to sell 2000 contracts? 500, 500, 500, 500…to four big locals. The big locals don’t say, “Um I only wanted a 68 lot…” In other words, they provide liquidity and sometimes get instantly run over. Or, sometimes it’s a great edge. If they get run over, the filling broker obviously knows it…and might make sure those market makers get a clean edge at the next opportunity. Either way, the 20 lot trader does not participate in the big flow. What I’m trying to express is this: if the local next to you is a big trader and feeds off of your orders, you expect him to be there when you’re trying to move size. You expect him to help you out when your count is off. After all, you both stand there every single morning. Is it sometimes not exactly “fair”? Yes, but it was incredibly fast and efficient (and visceral) in its time.
But that’s now an antiquated vignette…this idea of people standing next to each other in a physical location, and spitting on each other, and sweating on each other, and trading.
The Reality of LTCM
Let’s now go back to the Long Term Capital Markets crisis, when the Fed pulled all the big banks and investment houses together for the bail-out. Bear Stearns famously declined to be involved, and I’ve seen several accounts that said when Bear was going belly up years later, other investment banks turned their backs, just for that reason. I guess the point that I am tenuously trying to make is that liquidity has a very human dimension. Or maybe I should say HAD a very human dimension.
Where are we now? Bid/offers are generated by computers that link those bids and offers to other products. We’re in a world of ETF’s that are derivatives of derivatives. We have an “investing” public that has no idea what the connection between gamma and a 3x ETF might be. Investment ‘professionals’ that have absolutely no clue as to who might be taking the other side.
Now, let’s circle back to the idea of liquidity and implied volatility. Implied vol measures the cost of options…the higher the implied volatility, the higher the premium for a given option (holding other variables like the underlying price constant). If one thinks that it might not be possible to transact at a particular price level, then one might be willing to pay a bit more premium, i.e. insurance, for protection.
I’ve read several accounts of crises where people don’t have access to basic goods due to destruction of the societal fabric. One of the things held precious in these times is, surprisingly enough, toilet paper. A product that we all take for granted in the modern world. Well, we’ve all been taking liquidity for granted. So here’s my advice. Grab a roll of toilet paper and strap in. It’s gonna be a bumpy ride. And don’t worry about paying up for a little insurance. You might need it.
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For More from Alex Manzara, check out his Daily Blog
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