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STT Diversity Liquidity Black Holes (2)

STT Diversity Liquidity Black Holes (2)

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Published by: zerohedge on Jul 19, 2009
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This article was published in the Singapore Foreign Exchange Market CommitteeBiennial Report, 2001-2002. Thanks go to Natalia Alvarez-Grijalba of State Street andStephen Spratt of Sussex University for statistical assistance.
Liquidity Black Holes: what are they and howare they generated
 Avinash Persaud 
 
Gresham Professor of CommerceManaging Director and Global Head of Research, State Street
 
 
 April 2003
 
Page 2 of 9
Liquidity Black Holes
Why does liquidity matter?
Financial liquidity matters. In general market participants have a strong preference for trading in the most liquidmarkets, which partly explains the recent pressure for mergers and cross-listing agreements between stock marketsand the consolidation of electronic bond and currency exchanges. In a series of partnerships and cross-listings,European exchanges have coalesced around two groups and the London Stock Exchange is expected to enter into apartnership or merger shortly. The Singapore and Australian stock exchanges have entered into a partnershipdesigned to support liquidity.As important as the level of liquidity, is its
uncertainty 
. In an age where there is an intolerance for risks that cannot bequantified, investors avoid markets altogether where liquidity is uncertain. This is one of the reasons why portfolioflows to emerging markets are concentrated in a very small number of large markets, see chart 1. There is someevidence that investor preference for liquidity increased following the collapse of LTCM in September 1998, a hedgefund whose arbitrage strategies fatally depended on the maintenance of liquidity.It is of particular concern, therefore, that traders frequently talk of episodes in which the liquidity faced by a buyer orseller of a financial instrument virtually vanishes, reappearing again a few days or weeks later. Moreover, theseliquidity black holes, as I have coined them, are not confined to the usual suspects such as the Indonesian rupiahmarket in August 1997 or the South African rand in April 1998, but are said to occur in the largest markets. Tradersregularly swap war stories about liquidity black holes in the dollar/yen or sterling/dollar exchange rate or the USTreasury market. Liquidity black holes were certainly present in the collapse of major equity markets outside Asia in2002.
Chart 1: The proportion of gross cross-border equity flows to 17 emerging markets accounted for by just fivemarkets.
0204060801001201995199619971998199920002001Top 5 countriesAll other countriesPercent
Source: State Street Bank 
 
 April 2003
 
Page 3 of 9
Liquidity Black Holes
Issues of concept and definition
Liquidity and volatility are related, but separate concepts. A lack of liquidity will in most cases lead to volatility and sothe rise in volatility in major financial markets is supportive of the traders’ anecdotes, see chart 2. But it is not proof.Liquidity black holes will lead to higher volatility, but not all instances of higher volatility stem from a liquidity blackhole. The public announcement of new and surprising information which leads traders to move their bids significantlyto a new level will appear as price volatility, but reflects a well functioning market moving to a new equilibrium, not anilliquid one.An ill-functioning market would be one where that public announcement causes the price of an instrument to fall andthat fall then causes some market participants to sell, pushing the price lower still, causing more to sell. Price fallstriggering further sales. This is what is said to have occurred in dollar/yen trading in September 1998, or in the 30year US Treasury market in February 2001 or in the UK equity market this year as UK insurers responded to pricedeclines by selling equities. The kind of price move observed in a feedback loop like this is of a very differentcharacter to the original public announcement effect. In this unstable environment liquidity to sell (or buy) virtuallyvanishes only to reappear when the market stabilises. By a stable market we mean a market where buyers arebrought out by lower prices and sellers by higher prices.This definition opens up a dimension of horizons. A market may have many micro-black holes when looked at overperiods of a few minutes, but is stable when looked at over periods of a few days. The longer these periods last themore concerning they are. We are concerned with time periods long enough - say a few days and perhaps as longas a week - for liquidity black holes to yield significant costs to those who are dependent on trading on a particularday, say month or quarter end, or long enough to change an investment decision or at least potentially to do so. Anincreasingly large number of financial contracts use a market price of an instrument on a specific date or time on theassumption that the market price will reflect underlying valuation and not liquidity.

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