Saqib Iqbal Ahmad

NEW YORK (Reuters] – The liquidity in U.S. stocks fell to levels seen two years ago during the COVID-19 sellingoff, which added volatility to an already nervous market.

For years market liquidity has fallen. This refers to the ease with which investors can purchase or sell security securities, without any price impact. Recent weeks have seen traders be whippedsawed by huge moves.

Rishabh Bhhandari (senior portfolio manager, Capstone Investment Advisors), said that liquidity was “abysmal”, which is how he would describe it.

“If anyone wishes to transfer risk, there aren’t efficient mechanisms for people to do so.”

Analysts believe liquidity is being affected by passive and automated investment strategies and trading, which have overshadowed active investors who are able to buy and sell when it suits them. A number of brokers are also being discouraged from taking risks, they claim.

For example, on Thursday, Facebook’s parent Meta Platforms (NASDAQ:), plunged in its largest daily slide for U.S. stock companies, losing over $200 billion.

Wall Street’s fear gauge, the Cboe Volatility Index rose last month to a 15-month high of 38.94, amid a plunge in stock prices that left the Nasdaq down 9% and the S&P off 5.3% in January in the face of a hawkish shift from the Federal Reserve.

This liquidity issue isn’t limited to specific stocks. E-mini S&P 500 futures, one the world’s most widely followed financial instruments, are also flashing a danger sign.

Market swings are exacerbated by low liquidity. Investors find it more difficult to place buy or sell orders at the desired price. In March 2020, investors were concerned about an economic closure due to COVID-19, which led to market volatility.

Market depth is one indicator of liquidity in equity markets. Investors use this to gauge their exposure to U.S. stocks.

Futures typically trade at $50 million in notional value and are traded almost daily. This number dropped to $2 million by January end, which is close to the $1 million-to $1.5 million mark reached in March 2020 according to Capstone data. It now stands at less than $5 million.

(Graphic: Liquidity crisis, https://graphics.reuters.com/USA-STOCKS/LIQUIDITY/znpnejlybvl/chart.png)

A liquidity indicator shows that equity exchange traded funds make up 45% of all equity volumes. This is the highest level in at least two decades. JP Morgan says that low liquidity has led investors to use equity ETFs more frequently.

According to JP Morgan analysts, the equity market corrections of September 2021, October 2020, and December 2018 were caused by deteriorating liquidity.

The authors wrote, “A similar abrupt decline in equity market liquidity appears to have exacerbated recent market movements.”

The lack of liquidity was attributed to a number of factors by investors. One was that large brokers-dealers were less able to accept risk because of tighter regulation in the wake of the global financial crises.

A second factor is the change in marketmaking of securities, from people to machines. According to experts, trading programs may pull liquidity from markets when volatility is high, which could further exacerbate market movements.

Some investors also cited passive investment strategies as a reason for their success. While trading opportunities for active managers have been a source of liquidity in times of stress historically, passive and systematic strategies might not be permitted to trade due to restrictions on how and when.

Steve Sosnick is the chief strategist of Interactive Brokers (NASDAQ) and an ex-options market maker.

“As investors crowd into winning stocks, they become oblivious to the fact that it becomes increasingly difficult to exit en masse.”