Systemic Liquidity Risk and Bipolar Markets: Wealth Management in Today's Macro Risk On/Risk Off Financial Environment

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Precursors to Illiquidity

More than anything the 2007/8 global financial crisis showed how the proper functioning of capital markets cannot take place without systemic liquidity. Since markets began their recovery in the spring of 2009 there have been a number of occasions when the threat of system-wide illiquidity resulted in highly charged and disruptive market episodes. The Flash Crash of May 6, 2010 was one and in late July/early August of 2011 when the Eurozone woes took a major turn for the worse there were other sessions when large drops in equities, both intraday and inter-day, and other risk on assets arose. The fearful specter of the fragility of markets when liquidity evaporates has now been etched deeply into the collective psyche. There is good reason to believe that apart from all of the structural hurdles that need to be overcome, this emotional scarring will be a significant dampener to the “animal spirits.” One of the lingering doubts as to how long it may take to emerge from the kind of balance sheet recession which is still very much with us, can be traced back to the question: How long does it take for market participants to get over this residual fear about systemic instability and of markets “seizing up”?

In a proper theoretical framework which can explain the nature of systemic liquidity risk, it would be a major sign of progress for there to be a separation of the different types of factors which can contribute to market dislocations and the ensuing periods ...