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This week's gold crash reminds us of a much scarier risk in the markets

Sam Ro
Posted on 7/21/2015, 9:00 AM

panning gold

On Monday, gold crashed by more than 3% in just a matter of seconds.

And experts are still trying to come to a consensus over the cause of the stunning move.

"The move has largely been attributed to the prospect of Fed liftoff and the recent strong run in the dollar with attention moving back to the Fed after recent events in Greece and China," Deutsche Bank strategist Jim Reid wrote Tuesday morning. "Reuters are also suggesting that the mini flash crash experienced in trading in Asia yesterday (when gold tumbled nearly 5%) was exaggerated with the relatively low liquidity as CME circuit breakers triggered twice in just one minute with suggestions of large amounts of stop-loss selling."

There was even a rumor of forced selling in China, as reflected by the massive trading volume in Shanghai.

But all of these theories are more or less tied to one theme that Reid identified: low liquidity.

What is liquidity?

Broadly speaking, liquidity measures how easily traders and investors can buy and sell an asset in the market without seeing big price dislocations. When liquidity is low, selling can cause prices to plummet.

"I think of this as one of the most underappreciated risk factors facing most investors today," Allianz's Mohamed El-Erian said in May.

Not only is liquidity underappreciated, but it's also much more complex and nuanced than in the above definition.

low tide water boat drought liquid"Although there are potentially many different definitions of market liquidity, in its simplest form we think of a liquid market as one in which trades can be executed with some immediacy at low transaction costs," Deutsche Bank's Peter Hooper said.

"But even within this short and simple definition there are many uncertainties: Does this refer to all trades, regardless of size, or only trades of a 'normal' size? What constitutes a low transaction cost, and how do we best measure this? Because of these uncertainties, there is no single best metric for the level of liquidity in a market."

Oaktree Capital's Howard Marks offered a slightly less technical and slightly more philosophical definition: "The key criterion isn't 'can you sell it?' It's 'can you sell it at a price equal or close to the last price?' Most liquid assets are registered and/or listed; that can be a necessary but not sufficient condition. For them to be truly liquid in this latter sense, one has to be able to move them promptly and without the imposition of a material discount."

Why are traders stressing about liquidity?

This whole discussion about liquidity risk by the market experts wasn't about gold. Rather it was about the bond markets. Specifically, there are concerns about what might happen should the tide turn in the bond markets when 30 years of falling interest rates reverses at a time when the Federal Reserve is preparing to tighten monetary policy by forcing rates higher.

"Current concerns in the financial markets center around the absence of liquidity and the effect it might have on future market prices," Janus' Bill Gross said in June. "In 2008/2009, markets experienced not only a Minsky moment but a liquidity implosion, as levered investors were forced to delever. Ultimately the purge threatened even the safest and most liquid of investments."

janet yellen wave winkBut amid all this fear, even Fed chair Janet Yellen is sanguine.

"Despite these increased market discussions, a variety of metrics of liquidity in the nominal Treasury market do not indicate notable deteriorations," Yellen said last week during her semiannual testimony to Congress.

But that was last week. And sure, gold isn't bonds. But liquidity is a concept that is universal in the markets. And sometimes it will just vanish without warning.

"So this will give all of us worried about a lack of trading liquidity more ammunition that this cycle is behaving quite differently in this respect," Reid said.

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