Feature – Liquidity
ties 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 infra- structure 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, liquid- ity is always abundant. But as banks have retreated from pro- viding liquidity, hedge funds and other “shadow banking” enti- ties 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 cor- relation 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 da- ta 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 pas- sive 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 concen- trated, 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 institu- tional 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.
In volatile times, you want institutional investors to be the source of stability, not trouble.
Liz Fernando, Nest
Rising tide How has the crunch in market liquidity affected UK institu- tional investors? Mike Eakins, chief investment officer at Phoe- nix, says that equity market liquidity has deteriorated signifi- cantly. 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 big- gest issue in the past month. A number of them use LDI strat- egies 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 col- lateral 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 Fer- nando, 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 swim- ming pool disturbed by a large splash of water. The painting
24 | portfolio institutional | July–August 2022 | issue 115
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