The liquidity problem is not restricted to individual stocks. E-mini S&P 500 futures, one the world’s most widely followed financial instruments, are also flashing a danger sign.
Low liquidity exacerbates market swings and makes it harder for investors to execute buy and sell orders at a desired price. Episodes of scant liquidity contributed to wild market gyrations in March 2020, when the S&P 500 fell by about a third, peak-to trough, as investors worried about an economic shutdown related to COVID-19.
One measure of equity market liquidity is the market depth of S&P 500 e-mini futures, which investors use to gain exposure to the U.S. stock market.
These futures trade usually about $50 million of notional value at any given time. That number fell to around $2 million in late January, not far from the $1 million – to $1.5 million level touched in March 2020, data from Capstone showed. Now it stands at just under $5 million.
Another liquidity metric shows the share of equity exchange traded funds as a percentage of total equity volumes at 45%, the highest in at least two years. Low liquidity in individual stocks has pushed investors to increase their use of equity ETFs, according to JP Morgan.
In addition to the March 2020 selloff, deteriorating market liquidity contributed to equity market corrections in September 2021 and October 2020 and December 2018, JP Morgan analysts said in a recent note.
“A similarly abrupt deterioration in equity market liquidity conditions appears to have exacerbated recent market moves,” they wrote.
Investors pinned the dearth of liquidity on a variety of factors. For one, they said tighter regulations in the aftermath of the global financial crisis curtailed large broker-dealers’ capacity to take risk.
Another factor has been the shift to market making for securities from humans to machines. Trading programs sometimes pull back liquidity when volatility spikes, experts said, which can exacerbate market moves.
Also, some investors cited the rise of passive investment strategies. While active managers looking for trading opportunities have historically provided liquidity during times of stress, systematic and passive strategies may not be allowed to do so due to strict rules about how and when they can trade.
“Liquidity risk is grossly under-appreciated,” said Steve Sosnick, chief strategist at Interactive Brokers and a former options market maker.
“As investors crowd into winning stocks, they become oblivious to the fact that it becomes increasingly difficult to exit en masse.”
(Reporting by Saqib Iqbal Ahmed; Editing by Ira Iosebashvili and David Gregorio)