Yesterday, the stock market suffered the equivalent of a run-on-the-bank. Liquidity disappeared and prices nosedived, with the Dow spiraling down nearly 1000 points. Today the Dow faces another 3-digit-loss. Economist Paul Kedrosky explains in his blog today just how and why the markets are particularly vulnerable to bone-rattling volatility. As you doubtless already suspect, computer-driven trading is the chief culprit. But Kedrosky carves out a nuanced explanation on the ways algorithm-based trading has changed the market essence. Here’s Kedrosky in his own words:
There are fewer traders prepared to make a market for the sake of market health. This is partly because they can, but mostly because of what has happened with high-frequency trading, algorithms, and the like, which increasingly jump into the trading queue in front of and around orders, creating some liquidity, but also peeling pennies for themselves, frustrating market participants and heretofore liquidity providers, but in the course of normal business generally accepted as a price that gets paid to the market’s battle bots.
But all of this changes market microstructure in insidiously destabilizing ways. For the first time we have large providers of this shadow liquidity, algorithms and high-frequency sorts, that individually account for large percentages of daily trading activity, and, at the same time, that can be turned off with a switch, or at an algorithmic whim. As a result, in market crises, when liquidity was always hardest to find, it now doesn’t just become hard to find, it disappears altogether, like water rushing out sight via a trapdoor to hell. Old-style market-makers are standing aside as panicky orders pour in, and they look straight at shadow liquidity providers and say, “No thanks. You battle bots take it”. And, they don’t.