Liquidity Black Holes Avinash Persaud The Gresham and Mercer Memorial Professor of Commerce Managing Director & Head of Research State Street Global Markets April 2002 What is liquidity and why does it matter? • Speed, ease and cost of transacting • Recorded spreads are a poor measure • Poor liquidity is associated with volatility Price impact of trading -0.2 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 Jul-97 Mar-98 Nov-98 Jul-99 Mar-00 Nov-00 Jul-01 Mar-02 Emerging Market Sells Emerging Market Buys % return per basis point of market • Big price-impact = low liquidity • Liquidity is not one number • Liquidity is variable and this matters Liquidity Black Holes 0 10 20 30 40 50 60 78 Q1 79 Q1 80 Q1 81 Q1 82 Q1 83 Q1 84 Q1 85 Q1 86 Q1 87 Q1 88 Q1 89 Q1 90 Q1 91 Q1 92 Q1 93 Q1 94 Q1 95 Q1 96 Q1 97 Q1 98 Q1 99 Q1 00 Q1 01 Q1 5 year smoothed average Number of days Liquidity black holes: num ber of days per quarter that the US, Japanese and UK broad stock indices have moved by 2 standard deviations m ore than the average daily price m ove • There are episodes in which liquidity disappears and then returns • Liquidity black holes are becoming more frequent • Some markets are getting bigger and yet thinner Liquidity needs diversity • There is less diversity because – Information costs have fallen – Less diversity within and between firms – Switch to market-sensitive risk management systems Liquidity needs losers • Regulators are encouraging these trends • Defending diversity means accepting losses • Financial system needs more freedom Avoiding liquidity black holes Average number of Liquidity Black Holes per quarter Change from the last bubble to the previous FTSE 100 2.594 4.100 UK 10 year bond 2.784 -1.958 JP 10 year bond 2.986 -2.175 S&P500 3.078 3.133 Toronto SE 3.156 6.092 Topix 3.289 3.783 $/Yen 3.445 3.608 US 10 year bond 3.580 -1.667 $/CHF 3.742 -2.575 $/£ 3.766 -5.500 Euro/$ 3.898 -0.950 Conclusion • Liquidity black holes matter • Liquidity needs diversity and losers • Different asset classes have distinctive liquidity trends . accepting losses • Financial system needs more freedom Avoiding liquidity black holes Average number of Liquidity Black Holes per quarter Change from the last bubble to the previous FTSE 100. liquidity • Liquidity is not one number • Liquidity is variable and this matters Liquidity Black Holes 0 10 20 30 40 50 60 78 Q1 79 Q1 80 Q1 81 Q1 82 Q1 83 Q1 84 Q1 85 Q1 86 Q1 87 Q1 88 Q1 89. Q1 95 Q1 96 Q1 97 Q1 98 Q1 99 Q1 00 Q1 01 Q1 5 year smoothed average Number of days Liquidity black holes: num ber of days per quarter that the US, Japanese and UK broad stock indices have moved