CliffStack Summary 9: The Coming Liquidity Squeeze
Even as market illiquidity and volatility rises to ominous levels, all threats to market stability have been thwarted, but not for long
CliffStack summary from Concoda
Dated: 22/1/2023
Original reading length: 12-15 minutes
New length: 5 minutes
The Premise
Concoda delves into what’s behind the fears of yet another liquidity crunch and speculations on what may cause the next financial upheaval. In 2022, it was believed that an unwinding of central bank liquidity would lead to financial turmoil, but it did not occur due to the response from monetary leaders during the COVID market meltdown. Market participants have adapted to a low volatility environment and have reinforced it through their actions. Concoda discusses how this dynamic could change if there is a sudden departure of a large market participant or a move by regulators. Also notes that early signs of waning liquidity have emerged and that banks are becoming less willing to lend to each other in the unsecured interbank lending market due to regulatory costs.
The Brief
following an epic monetary bonanza, there is a risk-off environment and a "slow grind" lower in most risk asset classes.
trillions of excess liquidity have been able to neutralize levels of volatility that could cause trouble.
over time, market participants have adapted to a new environment of "slow grind" and reinforced it, shifting the market's structure to suppress volatility.
few are worried about protecting against losses or tail risks, and suggests that a major flaw of finance is that it often turns the tools meant to protect investors into crisis-inducing time bombs.
Concoda suggests that over the past few quarters, there have been early signs of this phenomenon playing out in derivatives markets, with market participants viewing buying protection via options as futile due to volatility suppression.
buying VIX products to hedge against falling stock prices was a losing trade last year.
lack of volatility, which typically spikes in bear markets, can be explained by the current status quo of a lack of a catalyst like a virus or banking panic to spark fear, making the latest market downturn uneventful.
volatility remains elevated but is contained by cash-rich participants.
speculators have started piling into options called "0DTE", making up 40-60% of daily options volumes, raising concerns of potential risks.
institutional traders are exploiting a new regulatory loophole in the options market by selling large amounts of deep out-of-the-money 0DTE options,
market is heavily concentrated, with a few types of players providing most of the liquidity and liquidity in the stock market has sunk during the Fed's tightening cycle, adding to the risk of volatility.
we are witnessing the largest compression since Volmageddon in an already illiquid market,
early signs of waning liquidity have emerged deep in the monetary system, with the spread between Fed Funds and SOFR suggesting that cash is becoming less plentiful.
the Fed Funds market, an unsecured interbank lending market, has almost disappeared due to regulations that discourage banks from lending to each other. Instead, the market for secured repo lending has grown significantly.
Entities now feel safer when borrowing directly from the Fed. JPMorgan found that around 30 small banks with total assets of less than $1 billion had fallen into negative equity as of September 2022, an increase from zero since the start of last year.
Consumers may be transferring their deposits into money market funds, Treasuries, and even the stock market as the Wall Street giants pay barely any interest.
In Summary
ChatGPT says the article predicts that liquidity problems could emerge in the market within six to nine months due to a slow withering of liquidity, suggesting that options with same-day expiries and the Fed's actions could cause turmoil in the market and that the Fed will have to pivot in response. However, it's uncertain when this will occur and what will be the trigger. Finally, when volatility suppression turns into a volatile blowup, the response from monetary leaders will be similar but in greater magnitude.
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