Liquidity is the lifeblood of the capital markets. It is the ease at which an asset can be turned into cash without disrupting the price of that asset.
This was never really a concern in the U.S., whose markets are prized for being the deepest, most liquid in the world. It's one reason why the dollar is the world's dominant reserve currency.
But liquidity has been slowly draining from various markets to the point where the Federal Reserve this month warned that it threatens financial stability.
Investors who ignore this warning do so at their own peril.
Liquidity can be measured various ways. In the stock market, these include average daily volume, top of book size (how many shares or contracts are on the bid and offer) or market depth, which is the total number of shares or contracts below the bid and above the offer.
There are many reasons for why liquidity has declined, starting with regulations in the stock market that have reduced incentives to display orders, meaning the willingness of market makers to post bids and offers on the screen.
More recently, the decline in liquidity can be tied to the Fed's plan to tighten monetary policy by raising interest rates and shrinking its almost $9 trillion balance sheet.
Don't forget, the Fed had been pumping $120 billion per month directly into the financial system since the early days of the pandemic by purchasing bonds in the open market.
Now, that money will be coming out. This has contributed to higher levels of volatility, which has an inverse relationship to liquidity. And in the futures markets, margin requirements can also affect liquidity. As they increase, it reduces the number of contracts an investor can trade without posting additional margin.
Stock market liquidity is the worst ever outside the financial crisis of 2007 and the early COVID-19 period.
The market for U.S. Treasury securities, called the most important in the world, is also seeing a reduction in liquidity. So much so that it is not unusual to see rapid and wide swings in yields for no apparent reasons. The Fed said in its report that "liquidity metrics, such as market depth, suggest a notable deterioration in Treasury market liquidity."
"Tick" size also contributes to liquidity shortfalls. A tick is the smallest increment that stocks, futures or bonds can trade. One tick in the stock market is one penny. Also, if the spread between the bid and offer is too small, that also reduces incentives to display liquidity, or post bids and offers.
I have been a proponent of rolling back decimalization in the stock market and going back to fractions, which would increase incentives for market makers to post bids and offers.
Most outside observers look at bid-offer spreads linearly, thinking that the wider they are, the more costly to investors. Yes, they may hurt the individual who buys 100 shares of General Electric Co. in his or her E-Trade account, but individuals are also investors in mutual funds and such, which transact in very large size and would benefit from the additional liquidity created by larger tick increments.
In stock index futures, tick sizes are extremely small, with the Nasdaq 100 futures trading in quarter ticks even as the index vaulted over 10,000. This benefits practically no one, except for high-frequency traders.
The lack of liquidity is a very complex problem that comes down to how the exchanges are compensated, which is in the form of small fees on a per-share or per-contract basis. More volume equals more fees which equals more profit.
I would hope that exchange officials are working to figure out how to solve this problem. The answer is simple: increase incentives for posting liquidity, and tick size is a small part of that. As bad as liquidity is, it is possible for it to get worse.
Dillian is the editor and publisher of the Daily Dirtnap and an investment strategist at Mauldin Economics.
