How did COVID-19 impact global stock market liquidity?

The COVID-19 pandemic exposed one of the major issues faced by global equity market makers: a downward liquidity spiral exacerbated by an increase in margin requirements

The outbreak of the COVID-19 pandemic caused some of the largest – and fastest – market dislocations in modern history. This caused a financial nightmare for stock markets around the world and exposed one of the major issues faced by global equity market makers – a downward liquidity spiral exacerbated by a significant increase in margin requirements the world over.

A press release from the only listed global equity market makers, Virtu Financial, for example, underscored market panic about the quick and coordinated evaporation of liquidity across global markets. “Given the sustained levels of extraordinary volatility in the current macro environment… we consider it prudent to opportunistically supplement our borrowing capacity.”

Indeed, Virtu required a temporary addition of US$450 million in additional broker dealer capital to continue their global market-making operations. Their announcement came nine days after the World Health Organization (WHO) declared COVID-19 to be a global pandemic, according to Dr Amy Kwan, a Senior Lecturer in the School of Banking and Finance at UNSW Business School.

“On 12 March 2020, U.S. equity markets experienced the worst daily market returns since the 1987 ‘Black Monday’ market crash,” she says. “The Dow Jones Industrial Average closed 9.9 per cent lower and the S&P 500 fell 9.5 per cent. These large drops in equity market values corresponded with sharp increases in margin requirements: the margin requirements for some exchange-traded equity products jumped by more than 300 per cent. At the same time, liquidity dried up.”

This issue was the focus of a recent research paper, Contagious margin calls: How COVID-19 threatened global stock market liquidity, co-authored by Dr Kwan, who wanted to understand whether margin requirements played a role in this sudden drop in liquidity.

Correlations between margin requirements and market liquidity                 

The declaration of the COVID-19 pandemic is associated with some of the largest dislocations in market history, says Dr Kwan, who found that binding margins lead market makers to withdraw from equity markets. This is because an increase in funding costs (higher margin requirements) correlates to a sharp reduction in market liquidity. Dr Kwan explains: “our findings are consistent with a negative liquidity spiral, in that higher margins limit the ability of some traders to provide liquidity, which forces these traders to withdraw from the market, causing declines in market values. So as the market becomes more illiquid, there is a further increase in margins, which forces even more traders to withdraw from the market – resulting in a negative liquidity spiral.”

Dr Kwan and her co-authors also found there were more significant drops in liquidity for index stocks (stocks tracked by indexes such as the Dow Jones Industrial Average or S&P 500 Index) relative to non-index stocks. Because high-frequency market makers (typically hedge funds and proprietary trading firms that employ automated algorithmic platforms to make large numbers of trades at extremely high speeds) are likely to be more sensitive to margin requirements than other traders, Dr Kwan says high-frequency market makers are more likely to withdraw liquidity when margin rises. “Because high-frequency market makers are more active in index stocks, we expect larger drops in liquidity for index stocks, relative to non-index stocks, which is consistent with our findings,” she says.

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Implications for equity markets and investors

Dr Kwan says the findings in the research paper have practical implications for equity markets, market regulators and market participants. For example, relying on a handful of high-frequency firms for liquidity provision in global markets could increase the systemic risk in equity markets. “When margins increase, these high-frequency firms are likely to withdraw simultaneously, leading to large negative liquidity spirals around the world,” she says.

Similarly, the withdrawal of high-frequency market makers when margins increase could also reignite the debate surrounding positive obligations for market makers. While market makers have an obligation to supply liquidity in some exchanges, Dr Kwan says other market makers can choose to supply liquidity only when it is profitable to do so.

The research paper made this point clear: “the significance of the capital constraints faced by high-frequency market makers has become particularly important in a world where the majority of liquidity is provided by only a handful of firms, such as Citadel and Virtu,” it says. “When these firms represent the majority of liquidity provision not only within a market but also across markets, the procyclicality of their available committed capital represents a systemic risk that should no longer be ignored.”

Reducing the impact of future market shocks

While the COVID pandemic has passed, Dr Kwan says there are three measures that market regulators could consider in order to potentially reduce the potential impact of significant market shocks.

Firstly, she suggested regulators might consider more stringent margin requirements for high-frequency market makers. “These high-frequency traders are often highly leveraged and thus, extremely sensitive to sudden increases to their margin requirements. As witnessed in March 2020, a jump in margin requirements could lead to their immediate withdrawal of liquidity from markets, resulting in negative liquidity spirals.”

Secondly (and as mentioned earlier) Dr Kwan says regulators could reignite the debate on market maker obligations. As the research paper notes, the increases in equity market margins observed during 2020 are some of the largest and fastest on record. “The associated withdrawal of high-frequency market makers has the potential to reignite the debates surrounding positive obligations for market makers. It is possible that market structure changes, such as imposing positive obligations on appointed designated market makers, or regulatory capital reserves to act as a ‘countercyclical buffer’ in times of stress, could potentially mitigate the liquidity crisis observed during such turbulent times,” the paper noted.

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Finally, Dr Kwan suggested there could be a review of the competition for liquidity provision. Currently, few major players dominate liquidity provision in global markets – a significant systemic risk if one of these players were to withdraw from the market. “However, it is important to note that any change to market rules and regulations could have unintended consequences and each rule change needs to be researched carefully to minimise potential negative effects,” says Dr Kwan.

Dr Amy Kwan is a Senior Lecturer in the School of Banking and Finance at UNSW Business School. Her research is primarily in market microstructure and focuses on how changes in a market’s design (for example, new trading venues, market participants, rules and regulations) affect trader behaviour. For more information, please contact Dr Kwan directly.