Liquidity Black Holes

Avinash Persaud
The Gresham and Mercer Memorial Professor of Commerce
Managing Director & Head of Research
State Street Global Markets
April 2002
 What is liquidity and why does it
matter?

• Speed, ease and cost of transacting

• Recorded spreads are a poor measure

• Poor liquidity is associated with volatility

 Price impact of trading
% return per basis point of market
-0.2

• Big price-impact = low 0.0

liquidity
Emerging Market Sells
0.2

0.4

Liquidity is not one

0.6

•
number
0.8

1.0

1.2

• Liquidity is variable and 1.4 Emerging Market Buys

this matters 1.6

1.8
Jul-97 Mar-98 Nov-98 Jul-99 Mar-00 Nov-00 Jul-01 Mar-02
 Liquidity Black Holes
Liquidity black holes: num ber of days per quarter that the
US, Japanese and UK broad stock indices have m oved by 2
standard deviations m ore than the average daily price m ove
Number of days

• There are episodes in 60

5 year smoothed average

which liquidity disappears 50

and then returns

40

• Liquidity black holes are 30

becoming more frequent

20

• Some markets are getting 10

bigger and yet thinner 0

78 Q1
79 Q1
80 Q1
81 Q1
82 Q1
83 Q1
84 Q1
85 Q1
86 Q1
87 Q1
88 Q1
89 Q1
90 Q1
91 Q1
92 Q1
93 Q1
94 Q1
95 Q1
96 Q1
97 Q1
98 Q1
99 Q1
00 Q1
01 Q1
 Liquidity needs diversity

• There is less diversity because

– Information costs have fallen

– Less diversity within and between firms

– Switch to market-sensitive risk management systems

 Liquidity needs losers

• Regulators are encouraging these trends

• Defending diversity means accepting losses

• Financial system needs more freedom

 Avoiding liquidity black holes

Change from the last bubble

Average number of Liquidity Black Holes per quarter
to the previous
FTSE 100 2.594 4.100
UK 10 year bond 2.784 -1.958
JP 10 year bond 2.986 -2.175
S&P500 3.078 3.133
Toronto SE 3.156 6.092
Topix 3.289 3.783
$/Yen 3.445 3.608
US 10 year bond 3.580 -1.667
$/CHF 3.742 -2.575
$/£ 3.766 -5.500
Euro/$ 3.898 -0.950
 Conclusion

• Liquidity black holes matter

• Liquidity needs diversity and losers

• Different asset classes have distinctive liquidity

trends