Liquidity dislocations during the pandemic

Over the course of the last few weeks we’ve experienced unprecedented moves in our markets, with major indices like the Nasdaq falling -28% from its highs, only to recover by advancing +31%. Meanwhile, the sudden and sharp decline in demand for oil resulted in never before seen price movements including a $50+ daily move into negative pricing.

While the rollercoaster ride has been either terrifying or exciting for traders depending on their positions and risk sizing – the end of day price movements are just the surface level story. The other, and for many…the more important part of the story, has been what has transpired in the market microstructure and liquidity as a result of the historical volatility.  The story of how the microstructure and liquidity of futures markets has changed, and in some ways perhaps remained consistent, during these huge daily moves appear to be catching the attention of sophisticated traders.

To dig into this, the team at RCM-X recently hosted a quantamental oil round table with our energy trading clients to discuss changes in fundamental factors like demand and to provide insights into the evolution of liquidity over the weeks since the start of the pandemic. Join RCM-X and ICE on the next webinar here. 

The main takeaway was that the increase in volatility has definitely impacted liquidity, as can be seen in the charts below demonstrating weekly observable diminished liquidity and the widening of price spreads in active CME Crude contract.

First things first – that light blue on the chart is the week Crude went down to -$37, and you can see the spikes in the bid/ask spread that this historic move brought with it. The darker blue line is the ‘base case’ of the analysis, representing the week of 2/17 before the pandemic panic was affecting markets in full force.

Adding it all up, the diminished liquidity and volatility likely resulted in higher trading costs in energy markets in March 2020 and April 2020. As we’ll discuss in our upcoming webinar, it wasn’t just energy markets experiencing this increase – we have noticed similar shifts in liquidity patterns across multiple products. Interestingly, while these factors related to liquidity, volatility, and trading costs appear to have increased during the course of the crisis, our analysis of intraday price returns suggests that market have exhibited efficiency in terms of prices. RCM-X suggests that market participants should consider reviewing legacy implementation / execution methodology as pre-COVID-19 order size increments or order durations may generate excessive impact.

Finally, in a complimentary piece the CME, in their piece analyzing the volatility spike and resulting liquidity, points out the amount of liquidity declined and the cost to trade went up (larger bid/ask spreads), but at a much slower rate based on their measure. Meaning, you pay more to execute a given size, but the costs may have been worth it in relation to the opportunity of completing your order given price risk. Think of it like paying twice as much to upgrade from the 300 level to tickets on the glass for a Blackhawks game. Yeah, you paid twice as much, but the experience may be 3 or 4 or 10 times better, oh also the season may or may not be canceled because of the pandemic.

The CME measures this by analyzing the cost to trade a market as a percent of the market’s average range. For example, in the E-mini S&P 500, the baseline for that stat (Nov 19 to Jan 20) was 1.1%, meaning your cost to cross the spread, in effect, was 1.1% of the average range. During the three weeks between Feb 24 and Mar 13, that stat went down to 0.29%, a decrease of -74%.

Here’s their breakdown of the increase in volatility, volume, cost to trade (see the paper for how they calculate that), and decrease (a good thing) in the cost as a percent of range.

As execution specialists, we view wider trading ranges as increased price risk coupled with a clearly increased liquidity cost. These changes in observable behavior demand a thorough review of legacy implementation / execution methodology as pre-COVID-19 order size increments or order durations may generate excessive impact.

To learn more about how liquidity continues to evolve, consider joining our upcoming joint webinar with the ICE on May 13th or contact RCM-X to learn more about how utilizing advanced execution algos can help you dynamically manage execution implementation.

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