Lessons in liquidity

submitted by Kevin Muir (this story originally appeared in the MacroTourist)


I started work on Canada’s biggest dealer’s institutional equity desk in the early 1990s. I was hired to help another trader whose large index client was increasingly taking more of his time. Back then Wells Fargo was the world’s biggest index fund and serving them took a fair amount of technical skill to execute the large baskets they wanted to transact. As my boss later told me, “there were candidates that had better computer abilities than you, and there were candidates that had more trading experience, but no one had your mixture of both skills.” I was lucky to be at the forefront of the computerized trading revolution, and therefore I progressed quicker than many other traders. Within a couple of years I had graduated from serving index clients to running a large equity index derivative book. Most of our trading was index arbitrage and making markets in ETFs for institutional clients, but we quickly became the biggest index player in Canada.

Although I was good at laying off risk through various markets, I was still a young punk that hadn’t been around the block. I took for granted the seemingly bountiful amount of bids and offers in all the instruments I traded.

As I became more confident in my abilities, I made markets in larger and larger chunks of stock index ETFs for institutional clients. The other liability traders on my desk would struggle when forced to buy a big piece of a single stock – although they could hedge some of the risk out with positions in other similar type names, there was still a ton of single stock risk. But for me it was easy to bid or offer a million of an ETF on the quote. Our group’s ability to lay off risk was much easier. We would wander into the stock index futures pit and wind down our position. When we ran out of locals to stuff, we would work out the balance through program trading. For some kid in his mid twenties, it seemed like an easy game.

But I still remember the first day I realized that liquidity is not always there when you need it. I didn’t learn this lesson on some big down day when the market went no bid at any price (that lesson was still to come). No, my first realization you can be bigger than the market came on some innocuous summer afternoon. There wasn’t much going on and many traders had split to golf (back in the mid 90s everyone golfed and my lack of this skill made me an unusual oddball on the trading desk). One of our agency traders got a call asking us to bid on a few million XIUs (which is the Canadian equivalent of the SPY). I think I bid down a nickel and he pasted me. We got to work trying to lay off the risk. My partner in the futures pit started making sales. I got on the offers with sell programs in the box. We moved down all the quotes and managed to sell a quarter of the position at a profit. The next quarter was sold at breakeven, and then it slipped below our cost. We kept selling, but the bids were quickly disappearing. Usually when you move quotes, the new price levels encourage more liquidity. Traders think they are getting a deal, and are eager to take advantage of the immediate demand for liquidity. Yet when we moved the quote down, this time there was nothing underneath.

As we continued selling, other traders started thinking something was up, and they began selling alongside us. Next thing we knew, the market hit an air pocket. We were still long more than a million XIUs and the market was suddenly in a little mini-free fall.

We knew that it was our selling that had caused this mini-crash so I did what every brash twenty five year does – we started buying. Yup, next thing we knew we were getting even more long desperately trying to stop the rout we started.

Eventually we decided this decline in Canadian stocks was just stupid, and we phoned up our contact in the Chicago pits to hedge out our position by selling a few hundred S&P futures. We waited it out overnight, putting on an imperfect hedge, unwinding our large long the next day when liquidity had returned to the Canadian stock market. I think we managed to only lose a little, but it was scary to realize how quickly the bids could disappear.

I was young and stupid. I didn’t yet understand that liquidity isn’t always there when you need it. No one had taught me the famous line about liquidity being too plentiful when you don’t need it and the moment you do need, it runs and hides. In the coming years as we were hit by the Russian default and then the Long Term Credit Crisis, I would come to learn the full extent of liquidity’s cowardice…