Richard Tomlinson – Interview
complex is in the spotlight now which isn’t
surprising. I’ve flagged
issues
around high-yield ETFs before, but I didn’t think it would hit investment-grade bonds in some of the areas it has. In equi- ties we have seen significant movements. When you look at the way markets oper- ate it is not that surprising.
If you think about who provides liquidity in these markets now and the way their risk management works it is not surpris- ing that liquidity shut down when things got as large as they did.
So ETFs have had a detrimental effect on market liquidity?
Liquidity in good times is better than it was, but, as market depth has imploded,
in stressed conditions liquidity evaporates. The reason is that banks cannot ware- house significant amounts of risk now. Banks aren’t there to provide liquidity an- ymore because of capital requirements and constraints on their balance sheets, which has changed massively. A lot of liquidity is now provided by hedge funds and high-frequency traders and many of those businesses run themselves with similar risk management profiles and can simply shut down if they don’t like the opportunity set in front of them.
So market makers are acting more like proprietary traders and liquidating their most liquid assets? Absolutely. We have observed that highly
liquid assets moved the most. That is of course completely understandable, if you have large top-down liquidations people try to shift risk using index positions, de- rivatives and potentially ETFs. The quick- est way to hedge that is to pick a basket of liquid index constituents. You wouldn’t trade in the smaller or mid-cap range.
So what is driving these massive swings in equities and bonds? There are short and long-term, as well as technical, sentiment and fundamental, factors at play. Part of the change is a more long-term, fundamental shift in outlook, whether that be with regard to interest rates and inflation or the funda- mental damage of the virus to the long-
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