This article first appeared as Beyond Liquidity on Markets Media. Beyond Liquidity is produced in collaboration with Liquidnet.
Jeffrey O’Connor, Head of Market Structure, Americas at Liquidnet, wrote about some current market dynamics, i.e., source of volumes, continuous market volume, impact costs, depth, correlations, volatility. Excerpts from his Mid-Year Review are below:
Let’s dive in.
Lately, attention seems to be on improving liquidity conditions and it is always important to understand the source of market liquidity. From an institutional perspective, much of the pattern of retail flows following equity performance don’t add much in terms of available liquidity, but some things have noticeably improved for traders and portfolio managers including book depth, lower correlations, and reduced volatility.
The retail army has a high incidence of following equity performance. This is a pattern going back to the beginning of 2021, which really showed up in 2022. With overall pressure on equities over the course of the year, a number of valleys presented opportunities with double-digit percentage gains to follow and with it, the noticeable shift from on to off-exchange executions.
(Still-poor-but-somewhat-improving) Liquidity Conditions
From most perspectives, liquidity is poor. High correlations and high cash-raise created a liquidity vacuum for the past year and a half with trading costs, real price volatility, low depth of book, etc., all contributing factors.Bloomberg strategist Cameron Crise recently pointed to a liquidity model/measure ofS&P 500 liquidity. While low vs. historical, there are some signs of improvement to go along with the rally of this year.
Overall market volumes were 13% higher through this period last year, but better liquidity points to better conviction and conditions would warrant as well. Discounting the macro, bull vs. bear tug of war—yield curve indicating recession, higher for longerFederal Open Market Committee (FOMC) messages, overbought (Nasdaq 100 touching 25% above 200-day moving average, equaling historical precedence of 4% of the time), stretched sentiment/positioning, elevated growth versus disinflation, soft landing, FOMC pause/pivot—it all totals to quite the battle.
Figure 5: Improving but Still Poor: Stock Market Liquidity Remains Well Below Average
The improved liquidity, however, may be confined to large caps. See Top of Book liquidity below (Figures 6 and 7), where the top 500 is much improved. Again, not at historical levels, but nearing three-year highs. While the small and mid-cap space sees a much more gradual improvement and does not depict notably improving conditions.
Figure 6: Liquidity (Top of Book Shares), July 2022 – June 2023
Figure 7: Liquidity (Top of Book Shares), Jan. 2023 – June 2023
Figure 10 illustrates the drying liquidity as measured by E-mini depth and extreme lows over the course of 2022. While the two-sided notional is still not attractive when compared with pre-Covid, below shows a broad CME E-mini contract on weighted averages of financial activity, where depth is sharply improved from the lows.
Figure 8: Drying Liquidity as Measured by E-Depth, January 2017 – June 2023
So what are the key takeaways from the first half of the year?In short, we are seeing glimmers of improvement.
Remember, risk variance rises with volatility. The price in time offers significant alpha capture time and again, however, that is countered by the natural defensiveness or skittishness towards conviction when prices are moving. For now, prices have stopped moving and with some of the other improving metrics, trading conditions are better than we’ve seen in some time.
Mid-July starts the earnings period and should go a long way towards settling the corporate expectations argument. The Consumer Price Index, Producer Price Index, Employment Report and FOMC meetings will continue to be the seminal events the market hangs its hat on but be aware – since May 3, 2023 FOMC hike and subsequent signal of a pause, total liquidity in the Liquidnet ATS on a daily basis is up 13% from the prior two month period with the S&P 500 up 7% and the Nasdaq up 12%.
When volatility subsides, three things occur:
- Dark trading increases: ATS stats as a percentage of overall market are showing signs of rising.
- Average trade size increases: Fear of adverse selection drop sand institutions regain control over the market making.
- Spreads start to drop: There’s less price risk so market making quoting gets tighter and the cost of trade drops.
Continuous volume is thin but poised to improve. It looks like a gradual move to conviction but when that conviction turns—which we are seeing signs of—there is cash to be put to work.
The full report, Mid-Year Review: Improved Equities Trading Conditions Are Asking for Conviction, can be read here.
