From Forbes India:
The lack of trading liquidity may not cause the next financial crisis but it will increase volatility and accentuate losses
Financial markets are currently concerned with the lack of trading liquidity despite the actions of central banks to maintain a seemingly unlimited supply of money.
There are two types of financial liquidity: The first is funding or the supply of money, and the second relates to the ability to buy and sell financial assets readily and without high transaction costs. Central bank policies have simultaneously created an abundance of money and a contraction of trading liquidity.
Trading liquidity is required where holders of securities, commodities and currencies wish to adjust holdings. This may be dictated by the need for cash, for example, when investors in a fund redeem their interest.
Investors and fund managers frequently over-estimate liquidity. Only a few stocks, major currencies and some government securities trade consistently, and in large volumes. Other assets trade less, particularly where market conditions are unfavourable. Michael Milken, the creator of junk bonds, identified this tendency: “Liquidity is an illusion... it’s always there when you don’t need it, and rarely there when you do.”
Today, trading indicators give the appearance of robust normality. But market turnover—the volume of trading relative to outstanding securities—in bonds and shares has fallen significantly. Government and corporate bond turnover has fallen by around 50 percent, in part reflecting the massive growth in issuance and outstandings.
Investors are likely to have greater difficulty in selling their holdings, especially large ones. They are also exposed to greater price volatility. Increasingly, markets are characterised by low day-to-day volatility, but more frequent, large price changes. In October 2014, US government bonds rates moved by 0.40 percent in a few minutes. In early 2015, German government bond yields rose from near zero to 0.80 percent in a few days. Statistically, these should occur once in several billion years.
There are several factors driving the problem.
First, central bank policies of low rates and abundant liquidity have driven investors into riskier, less liquid assets in search of returns. Large purchases by central banks have created an artificial scarcity of low-risk securities. Investors have been forced to invest in longer-dated securities, corporate bonds and emerging market issues. In many cases, the issuer is of low, non-investment grade credit quality. They have purchased less actively traded shares or invested in smaller and often less-developed equity markets. Investors may not recognise that the additional return does not compensate for the additional risk of reduced trading liquidity.
Second, with markets and prices increasingly driven by changes in official policy, investment horizons have become shorter, making additional claims on market liquidity. Many investors are purchasing assets they would normally shun for short-term gains on the assumption that they will be divest positions to a ‘greater fool’ before prices fall. This game of investment musical chairs relies on predicting when the music will stop, which most market participants are poor at....MOREHT: Alpha Ideas