There is a lot of concern that liquidity in some markets is so dire it could lead to some serious meltdowns. Eyes have been on High Yield via the energy sector but the perennial debate over corporate or emerging market debt liquidity risk rolls on. So here I post my strong feelings that I have expressed in this space before
But should we be concerned about a meltdown caused by low liquidity? The normal response is "Yes of course! Prices will collapse and there will be high volatility and and and" but am I allowed to ask “So what? Does that matter?"
If there is a meltdown in something it's triggered by an adjustment in perceived value. When there is no liquidity then prices pass through where people think fair price sits (otherwise they wouldn’t be moaning about a lack of liquidity) to prices which they feel are unfair or downright silly and don't reflect actual probabilities of default or yield outcome. So why are they selling at values that they think are absurd and moaning that it's due to lack of liquidity?
Most likely it can all be boiled down to money management rules creating large gaps between actual outcome probabilities and priced probabilities. This is particularly true in systems that use price as an input of probability in the first place, as we saw with CDS prices being quoted, wrongly, as actual probabilities during the EU crisis. So we could argue that any huge swings in pricing because of lack of liquidity will punish those who have to employ short term money management rules over those who can take a sanguine long term view. So rather than all being bad, it creates opportunity and acts as a feedback hopefully moving fund management away from the, sometimes cretinous, short term consultants tight risk rules back towards a more balanced macro big picture world.
But what about the losses? Well if the true price that reflects future outcomes has indeed moved then tough. That is nothing to do with liquidity. For those who are being forced to sell below what they see as the real price, due to no liquidity, their loss must be someone else’s gain as those selling must be selling to someone else who is picking up a bargain. So the negatives due to bad liquidity are offset by someone else’s positives.
So if there is to be a High Yield meltdown due to poor liquidity I look forward to buying some at stupid levels caused by some VAR calculation deep in a fund saying 'spew at any cost'. Thank you.
Of course the wealth destruction argument is different. If leverage is involved, which of course it is, then book values will tank and no doubt the value of that book has been used to borrow to fund some other asset, which then has to be sold. Now THAT is the transmission risk to other asset classes.
It's not liquidity that is the problem, it's once again leverage.