Imagine if a retail stock-picker invested their life savings in cryptocurrencies last year after being inspired by an advert for a trading platform where American actor Matt Damon declared: “Fortune favours the brave”. Well, if they did, their investment would have lost 70% of its value by now. The bad news does not end there. The investor may not even be able to withdraw what is left of their hard-earned cash as many crypto platforms have temporarily suspended trading due to “market volatility”.
Luckily, institutional investors are unlikely to have significant exposure to cryptocurrencies. But the demise of these assets shows how fickle market liquidity, the ease of buying and selling assets, can be. And some argue that crypto markets may well be the canary in the coal mine of an inflated market that is
about to dry up.
The Covid pandemic triggered an unprecedented injection of central bank liquidity into the markets, with the Fed’s balance sheet expanding to $8.9trn (£7.2trn) from $4trn (£3.2trn) in the two past years. But this is coming to an end due to rising inflation and the prospect of monetary tightening.
That is a concern for institutional investors who rely on a degree of liquidity in their portfolio, not just to pay their members’ benefits but also to manage potential margin calls and manage their assets effectively. But why have markets dried up so rapidly? How are institutional investors experiencing the sudden deterioration in trading conditions? What strategies are they using to avoid running out of cash?
Tightening
Central banks have started the process of monetary tightening and the market response has been dramatic. Since the beginning of this year, stock market indices across developed markets have lost more than 20% of their value and that in turn has affected the ease of buying and selling assets.
The US Federal Reserve’s latest Financial Stability Review warns that “the risk of a sudden significant deterioration [in liquidity] appears higher than normal”. This is despite the US central bank sitting on a record high balance sheet of almost $9trn (£7.3trn). “Declining depth at times of rising uncertainty and volatility could result in a negative feedback loop, as lower liquidity in turn may cause prices to be more volatile,” the Fed warns.
Across equities, bonds and commodities, market depth – the ability to absorb large orders without significant price fluctuations – has deteriorated. The number of futures contracts for equities and oil has fallen to a low last seen in early 2020, when the outbreak of the pandemic caused an initial liquidity
crunch, according to Refinitiv.
Similarly, depth has deteriorated for bonds with shorter maturities as investors anticipate the effects of further rate hikes. Moreover, US and European initial public offerings (IPOs) have fallen by more than 90%, year to date, an indication that firms are finding it harder to raise cash from public markets.
But the Fed also notes that while market depth has worsened, bid/ask spreads remain relatively stable in the liquid segments of financial markets, which suggests that liquidity providers are moving towards executing larger trades in multiple smaller transactions, the central bank says.
Across the pond, the Bank of England is keen to reduce the size of its balance sheet, which is close to £1trn. But widening bidoffer spreads in the short-term gilt market is leading some commentators to suggest it should slow down the process of monetary tightening.
High-frequency hosepipes
But the problems with market liquidity go beyond monetary tightening, says Richard Tomlinson, chief investment officer at Local Pensions Partnership Investments. He believes that the retreat of banks from some trading and market making activities and the emergence of hedge funds and other institutional
investors as liquidity providers has made markets more prone to bouts of extreme volatility and liquidity squeezes.
“The regulation post-global financial crisis changed the infrastructure of public markets and I worry about where liquidity is sourced in public markets now. We have a fragile situation. There is this idea that there is more liquidity than there was 10 to 15 years ago, but it is state dependent. In good times, liquidity is always abundant. But as banks have retreated from providing liquidity, hedge funds and other “shadow banking” entities have taken over. Many have the same risk management approaches with no obligation to provide ongoing two-way prices. There are certain conditions where it makes sense for
them to provide liquidity and certain conditions where it does not. That is when you will get a volatility blowout,” he says. “Most markets normalise pretty quickly with volatility and correlation mean-reverting as rapidly as they spiked. At that point, there is money to be made,” he adds.
Another key factor, according to Tomlinson, is high-frequency trading. “Players de-leverage quicker, but they are also quicker to get capital back in. Fifteen to 20 years ago you could make money with low-latency execution and hourly or even daily price sampling or statistical arbitrage. These days, you are not
going to be able to make money unless the frequency of the data you are working with is way higher,” he says.
This goes hand in hand with the growth of passive investment strategies and index trackers, because hedging trades in passive funds are generally conducted electronically. The European Central Bank (ECB) warned in a 2018 Financial Stability Report that ETFs have the potential to transmit and amplify liquidity
risks in the financial system. ETFs tend to be held for their liquidity. But in the event of a crash, there is no obligation for ETF market makers and authorised participants to step in and provide liquidity.
Market making and share creation in the ETF market is highly concentrated, with the five biggest authorised participants providing liquidity for more than 90% of bond ETFs traded in the UK, according to research from the Financial Conduct Authority published in 2019.
Passive strategies have also become a cornerstone of institutional portfolios. The vast majority of defined contribution (DC) assets and around 56% of defined benefit (DB) equity portfolios are passive, according to Mercer, as are 46% of DB bond portfolios.
Rising tide
How has the crunch in market liquidity affected UK institutional investors? Mike Eakins, chief investment officer at Phoenix, says that equity market liquidity has deteriorated significantly. However, as an insurer Phoenix mainly operates in the fixed income markets. “Government bonds and credit markets, the areas where we mainly operate, are still functioning but we are seeing weaker demand for lower-quality credit which is to be expected in a period of rapid central bank rate hikes and concerns about economic growth and high inflation,” he says.
In contrast, fixed income liquidity has been high on the agenda of the schemes that Calum Mackenzie, investment partner at Aon, is advising. “For DB pensions, liquidity has been the biggest issue in the past month. A number of them use LDI strategies which often are leveraged. They are now getting margin calls to top up the collateral because the value of their assets has fallen so significantly. With gilts falling at 20% plus, you will have burned through the collateral you have had and that means pension funds are having to top up and sell assets such as diversified growth or even equities. Particularly the pension funds using pooled LDI strategies have now been asked for collateral at a few days’ notice,” he says.
The situation is a lesser concern for DC schemes, which are highly liquid, not just due to their regulatory setup, but also the regular contributions coming in from members, says Liz Fernando, deputy chief investment officer at Nest. Nevertheless the master trust is acutely aware that members could in theory
decide to withdraw cash in the event of a crisis. “Although our surveys show that members will react to market stress, we have never seen that. This does not mean it will not happen. Maybe if the pensions dashboard arrives it will, but for now we are not seeing that,” Fernando says.
A bigger splash
David Hockney’s 1967 painting A bigger splash shows a swimming pool disturbed by a large splash of water. The painting showcases the contrast between the speed of the moment from someone jumping from a diving board and the static nature of the remainder of the painting. Similarly, institutional investors
face the challenge of adapting to sudden changes in a portfolio that is otherwise relatively static.
As an insurance investor, Phoenix’s strategy centres on matching assets to liabilities. Being predominantly invested on a buy-and-hold basis, Mike Eakins is confident his portfolio can sustain challenging trading conditions. But he also sees opportunities for higher returns. “The other bit to notice about less liquid markets, especially in fixed income, is that it goes both ways. Spikes in short-term yields can expose company and government risks and they may have to refinance at higher yields,” he adds.
But margin calls continue to be a risk Phoenix monitors closely, particularly in its derivatives portfolio, Eakins says. “We have a collateral management framework, which we have had in place for a number of years. So we manage our potential collateral on an intraday basis.
“We continue to scenario test as collateral flows. While we are not sanguine about the current market circumstances we should have a degree of confidence given the robustness of our collateral management framework,” he adds.
For Tomlinson, a key priority is to avoid being a forced seller. “In our portfolios, we have a limited amount of contingent-capital exposures or non-linear triggers that can lead to large cash calls,” he says. This is a lesson he has drawn from his experience of the 2007 crash.
“The horror scenario is a full sell off in a market where you have a big and illiquid position. Think Archegos,” Tomlinson adds. “We have seen this before and this is the thing that people who have been through multiple cycles look out for. Back in 2007, someone wise said to me: Bear Stearns is just a mackerel.
At some point, the whale will float to surface. In a systemic crisis, you get liquidity withdrawals from the smaller guys who cannot get systemic help and go pop. But there is usually someone out there, the monster, who is in trouble. Back in 2007, it was Lehman and later other big players.
“In almost every crisis, there is someone out there who is systemic and global and has a problem. Asset markdowns will ultimately be feeding through to endowment and pension fund portfolios. And last time around, some big endowments got caught on the wrong side of the liquidity crunch and ended up with fire-sales of illiquid assets to raise cash,” he says.
The challenge for pension funds going forward is to hold sufficient amounts of cash to respond to short-term market challenges, without losing income to inflation, says Aon’s Calum Mackenzie. “We have been encouraging pension funds to have strong collateral, we call it a collateral waterfall or a collateral
ladder, so that they would have a certain buffer of cash or gilts.
That would be the immediate first call and the next stage of the waterfall would often be liquid credit, things like asset-backed securities, short-dated bonds, floating rate notes or absolute return bonds. These assets are low risk and can be accessed at short notice. But they are not officially collateral. And then the third tier down from that would be more or less liquid assets that you might need to tap into. For example, diversified growth, hedge fund equity and so on,” he says.
Liquidity will continue to play a crucial role, Mackenzie predicts. “There is definitively an understanding that your cash position is important right now. You could have a situation where you get a call from your private equity fund, or your infrastructure fund wanting money to make an investment, at the same time as you can get a collateral call from your LDI manager, wanting money to top up the collateral at the same time as paying pensions and then transfer values being hit.
Knowing that you have enough money is important,” he says. While for DC funds like Nest, holding enough cash is less of a concern, deploying it effectively in a volatile market can be tricky. The master trust has awarded a derivatives mandate to rebalance its exposures in challenging market environments
and equitising cash for private equity investments. “The efficient portfolio mandate was created to avoid situations where we are sitting on large amounts of cash waiting to be invested and not earning a return,” Fernando says.
As DC assets continue to grow, she sees the opportunity that such schemes could become important providers of long-term market liquidity, at a time when DB schemes are approaching their endgame. “In volatile times, you want institutional investors to be the source of stability, not trouble,” Fernando says.
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