This time on the Financial Sense Big Picture, Jim Puplava discusses why he thinks disappearing liquidity could be the next big unseen factor that might kick off a crisis. There are three large forces precipitating this coming crisis, he noted: high-frequency trading, the ETF and passive index fund fad, and government regulation.

Liquidity Is the New Leverage

Liquidity could become a serious problem for basic market operations, Puplava noted, and high-frequency trading is the match that could start the fire.

Whenever we head into a bear market, Puplava noted, there's always one factor that nobody sees coming. As Goldman Sachs recently warned, “liquidity is the new leverage if we head into another downturn.”

On a daily basis, almost 90 percent of trading on exchanges is carried out through high-frequency trading and index investing, Puplava noted. In the words of recent FS Insider guest Don Coxe, markets are no longer driven by humans but by machines, and machines know the price of everything but the value of nothing.

In the event of a major macro event or worse, a monetary event, we could see markets move down rapidly, such as happened during the Flash Crash and also the Taper Tantrum. A minor correction is magnified because as HFT enters the picture, bids happen in nanoseconds and HFT traders withdraw liquidity from the market.

Additionally, it isn’t just equities that will be impacted. Bond markets, commodities, currencies, and more are now bought and sold largely through HFT. As these split-second trades go bidless, reducing the price at which someone steps in, it can drive markets down in the blink of an eye.

“Machines — and not humans — are making trading decisions,” Puplava said. “Humans have the ability to process complex macro information. … The result is, we're seeing more instances where this occurs in this decade as the machines take over the market. … This feedback loop kicks in as investors interpret this price decline as confirmation that there must be news out there that's really bad.”

Passive Index Investing Stacking the Deck

We’re seeing a greater concentration of risk among passive index funds and ETFs. The top 10 holders of the FANG stocks are all index funds, for example, Puplava noted.

This is the next bubble, Puplava stated. Today, index funds account for 43 percent of all stock fund assets, and this is projected to be 50 percent in the next 3 years, according to Barrons.

In total, index funds represent $7 trillion of U.S. stock funds that have no active manager. All buying and selling are done automatically. Active management has gone out of fashion, Puplava noted, and as this sea change occurs, the market's ability to price companies diminishes.

Ownership of stocks in the S&P 500 is concentrated with three companies; Vanguard, BlackRock, and State Street. They represent about 88 percent of the S&P 500, and if we include Schwab and Fidelity, over 90 percent of the S&P 500 is basically now in the hands of five companies.

The concentration of risk is a problem across the asset spectrum. For example, the largest bond mutual fund ETFs have invested 15 percent or more of their money in rarely traded securities. Another issue is capacity, as some ETFs have taken on so much capital, they have become too big for the indexes they represent.

This may leave us facing nasty results, because in the event of a market downturn, as these ETFs and passive index funds crowd to exit their positions, they create a market liquidity trap as there is no one left to sell to.

“It's really mindless investing,” Puplava said. “The crux of the problem is that mutual funds own more bonds that seldom trade than ever before, but they're still promising to pay out investors within seven days of redemption, a promise they may not be able to fulfill in the next downturn or crisis.”

Regulation Is Making Matters Worse

Regulation has reduced the number of Wall Street firms and bond trading desks with traditional sources of liquidity, Puplava noted.After the financial crisis in 2008, legislation was introduced — such as Dodd-Frank — meant to restrict bank trading desks.

Today, bond ETFs are at historic highs and totaled more than $3.6 trillion in the first quarter of this year, up $2 trillion dollars since 2008. At the same time, bond dealers’ inventories have fallen from 4 percent of outstanding bonds to a mere half a percent today, from about $250 billion down to about $30 billion.

Many large trading houses are selling their inventory because they have to meet capital requirements, another issue created by regulators. As a result, Puplava noted, bond trading has become less lucrative as prices become more transparent. Regulators are requiring banks to pay for more risk and investors are becoming savvier.

Basically, banks are losing interest as regulations have increased. Additionally, as interest rates have fallen, banks aren’t holding bonds the way they used to. Instead, they dump these bonds to investors or institutions.

This phenomenon is going global, Puplava noted. This week, it emerged that in Europe, banks are giving up their primary dealership roles in dealing European government bonds. This issue threatens to further reduce liquidity and eventually make it more expensive for some countries to borrow money.

“What makes matters worse is regulators,” Puplava said. “They don't understand risk and don't often understand the consequences of their own actions. What's going on regulatory wise in Europe and what went on here is shrinking bond market liquidity. … They're shooting themselves in the foot because the government is dependent on a very liquid, transparent market to sell its bonds, especially now when you consider that we're heading back to trillion dollar deficits here in the US.”

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