persaud-liquidity black holes

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
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
Jul-97 Mar-98 Nov-98 Jul-99 Mar-00 Nov-00 Jul-01 Mar-02
Emerging Market Sells
Emerging Market Buys
% return per basis point of market
• Big price-impact = low
liquidity
• Liquidity is not one
number

• Liquidity is variable and
this matters
Liquidity Black Holes
0
10
20
30
40
50
60
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
5 year smoothed average
Number of days
Liquidity black holes: num ber of days per quarter that the
US, Japanese and UK broad stock indices have moved by 2
standard deviations m ore than the average daily price m ove
• There are episodes in
which liquidity disappears
and then returns
• Liquidity black holes are
becoming more frequent
• Some markets are getting
bigger and yet thinner
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
Average number of Liquidity Black Holes per quarter
Change from the last bubble
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