When Liquidity Vanishes

I've been traveling lately so I've had less idle time to come up with halfway interesting material to post. I'm still working my way through Bookstaber's demon of a book. He covers a lot of ground, not always in chronological order and it's a little all over the place but I'm finding many gems.

For example, he brings up one of the key assumptions underlying the perfect market model namely that markets are liquid enough so that buying and selling even in large quantities do not affect prices. Anybody with even a minuscule exposure to real life markets knows this assumption to be ludicrous. Liquidity, perversely, seems to be there when it's not needed and vanishes when it's most needed. When there is panic selling, liquidity dries up faster than a puddle of water in the Sahara desert.

Not only that but big orders do move prices even in liquid markets under normal market conditions. Why is that? Because of the adverse selection problem faced by market makers: if a big sell order, say, comes a market maker's way, he or she has no sure way of knowing if the seller is selling for benign reasons (portfolio rebalancing, for example) or if the seller knows something the market maker doesn't know (new negative fundamental news on the stock for instance). The market maker also doesn't know if the seller is done or if that sell order is only the first of a flood of sell orders. The MM is rightly scared of being tricked into catching the proverbial falling knife.

So what's a rational market maker to do? He or she drops the bid, substantially so if need be. So here you have a liquid market with no news out and yet a sell order can start a kind of psychological chain reaction resulting in a price dislocation. The 1987 crash is one extreme example of just such a phenomenon, taken to its grotesque caricature. On that fateful day, the more the NYSE specialists lowered their bids to attract potential buyers and bottom fishers (and to cover their asses), the more panic they created for the very simple reason that any rational market participant watching the price dislocations concluded that something really bad was going on and ran for cover. The lower bids actually scared away all the buyers. Very similar events took place in the Falls of 1997, 1998, 2001 and 2008.