Aurora Borealis
1 February 2013 CFA Institute Journal Review

Evaporating Liquidity (Digest Summary)

  1. Georgeann Portokalis

Demand for liquidity increases during a financial crisis, but the supply diminishes as a result of increased risk aversion, funding constraints, and reduced competition among market makers. Liquidity providers, therefore, should expect to earn higher returns in times of financial turmoil. The author studies the equity markets to quantify the increase in returns from equity liquidity provision during such periods and finds a related reduction in downside risk.

What’s Inside?

The author seeks to determine how short-term returns for providing liquidity to equity markets during a financial crisis compare with such returns under normal conditions. He shows that returns were close to 1% per day during the Long-Term Capital Management bailout and the bursting of the NASDAQ bubble. After the NASDAQ collapse, returns gradually fell to less than 0.2% per day until the crisis that began in 2007, when returns surpassed 1% per day. Liquidity providers not only earn more during a crisis, but they also earn it with less downside risk.

How Is This Research Useful to Practitioners?

The author’s work reveals that market makers extract concessions from investors who sell during a crisis, either because they are fearful or because they need liquidity. Institutional investors, well-capitalized individual investors, and traders that have excess liquidity during times of financial stress can use this information to earn outsize returns with low downside risk.

The liquidity business is attractive, but high-frequency trading entails high fixed costs that act as a barrier to entry. Liquidity providers, which are defined as market makers, informed traders, or liquidity traders that avoid holding inventory overnight, may earn 0.1% per day (25% annualized), on average, buying large, low-volatility stocks during times of financial stress. They earn more on lower-quality stocks even during normal circumstances (up to 0.4% per day). These figures, moreover, exclude the type of high-frequency, intra-day trading activity that is characteristic of algorithmic traders.

Liquidity providers generally also earn a higher return per unit of risk during crisis periods, which is illustrated by higher Sharpe ratios. Downside risk is not likely to explain the higher Sharpe ratios because returns are positively skewed even during normal circumstances. The author uses a reversal strategy technique to approximate trading activity under such conditions and finds positive returns to liquidity provision for all rolling three-month periods for individual stocks using end-of-day pricing.

The volatility index (VIX) provides an estimate of subsequent period S&P 500 Index implied volatility by averaging the implied volatility of selected options over two expiration months. The author finds that the VIX is strongly and positively correlated with expected equity liquidity returns, especially since the 2007–09 financial crisis.

How Did the Author Conduct This Research?

To replicate returns for liquidity providers, the author uses a simple reversal strategy that mimics market-making activity: buying stocks that have declined in price over preceding days and selling stocks that have risen. In his predictive regressions, the VIX level is lagged by five days to accommodate portfolio reversals conditioned on lagged expected daily returns.

Using data from the beginning of 1998 to the end of 2010, the author studies the time variation of returns for individual equities based on end-of-day closing prices and the midpoint of end-of-day bid–ask spreads to segregate returns earned through adverse selection from those derived from order imbalance absorption. He finds that the returns for end-of-day closing prices are higher. He also investigates the results for inter-industry portfolios that show elevated returns during crisis periods, although these returns are not as high as those earned for individual stocks.

The VIX is positively correlated with the returns of the reversal strategy, and the relationship is shown to have strengthened beginning in 2007. The author studies both expected volatility and the volatility risk premium reflected in the VIX. This task is complicated because these components correlate highly with the VIX and with each other. He hypothesizes that expected volatility is primarily associated with liquidity demand whereas the risk premium is mainly correlated with liquidity supply. Further research may help confirm this hypothesis. Although such liquidity supply factors as expansion in dealer repurchase financings and the Treasury–Eurodollar (TED) spread have been found to predict reversal strategy returns, they do not predict them as well as the VIX in the author’s study.

Abstractor’s Viewpoint

Because liquidity providers expect to be well compensated during a financial crisis, security holders should sell during such times only if forced—such as a mutual fund manager experiencing requests for redemptions. For individual investors and their financial advisers, this study exposes the folly of selling stocks into market turmoil as well as the benefit of buying large, liquid, and low-volatility stocks at low prices during times of high VIX levels.

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