Liquidity Black Holes

The most severe liquidity crises occur when we have “liquidity black holes”. In a normal market, when prices fall, some people will want to buy. During a serious crisis, many people may want to sell simultaneously. A liquidity black hole results when virtually everyone wants to sell in a falling market.

The crash of October 1987, on the New York Stock Exchange is a good example. Many traders followed a strategy of selling immediately after a price decline and buying back immediately after a price increase. As a result of this strategy called portfolio insurance, the initial decline in prices fuelled off further rounds of price declines and the market plunged sharply. In fact, the market declined so fast and the stock exchange systems were so overloaded that many portfolio insurers were unable to execute the trades generated by their models.

Herd behaviour, which lies at the heart of liquidity black holes, can cause the market to move completely to one side. Hull[1] has listed some of the reasons for herd behaviour:

Different traders use similar computer models and as a result pursue the same strategy. This can create tremendous selling pressure at the same time.
Because they are regulated in the same way, banks respond to changes in volatilities and correlations in the same way.
People start imitating other traders thinking there “must be something in it.”

Let us understand briefly how a uniform regulatory environment, i.e., similar rules for all market participants, may accentuate a liquidity crisis. When volatility increases, value-at-risk (VaR) will increase. Consequently, all banks will be forced to increase their capital.
Alternatively, they will have to reduce their exposure in which case many banks will try to do similar sell trades. In both situations, liquidity needs will suddenly shoot up and a liquidity black hole may result.

For black holes not to happen, at least some of the market participants should pursue contrarian strategies. Investors can often do well by selling assets when most people are buying and by buying assets when most people are selling. One reason for Goldman Sachs’ seemingly smart recovery from the sub prime crisis in the early part of 2009, seems to be this kind of an approach.

Volatilities and correlations may increase but over time, they get pulled back to the long term average. As such, there is no need for long term investors to adjust their positions based on short term market fluctuations. One way forward is for regulators to apply different rules to asset managers and hedge funds. If regulations are different, there will be diversity in the thinking and strategies of different market participants. Consequently, there is less likelihood of black holes developing.
[1] Risk management and Financial Institutions