T8-R44-P2-Hull-RMFI-Ch24-v3 - Study Notes

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P2.T8. Liquidity and Treasury Risk Measurement and

Management
John C. Hull, Risk Management and Financial

Institutions, 5th Edition
Bionic Turtle FRM Study Notes

Hull, Chapter 24: Liquidity Risk

EXPLAIN AND CALCULATE LIQUIDITY TRADING RISK VIA COST OF LIQUIDATION AND LIQUIDITY-
ADJUSTED VAR (LVAR). ........................................................................................................... 3
IDENTIFY LIQUIDITY FUNDING RISK, FUNDING SOURCES, AND LESSONS LEARNED FROM REAL CASES:
NORTHERN ROCK, ASHANTI GOLDFIELDS, AND METALLGESELLSCHAFT. ...................................... 9
EVALUATE BASEL III LIQUIDITY RISK RATIOS AND BIS PRINCIPLES FOR SOUND LIQUIDITY RISK
MANAGEMENT. ........................................................................................................................12
EXPLAIN LIQUIDITY BLACK HOLES AND IDENTIFY THE CAUSES OF POSITIVE FEEDBACK TRADING. ...16
2
Hull, Chapter 24: Liquidity Risk

 Explain and calculate liquidity trading risk via cost of liquidation and liquidity-
adjusted VaR (LVaR).
 Identify liquidity funding risk, funding sources, and lessons learned from real cases:
Northern Rock, Ashanti Goldfields, and Metallgesellschaft.
 Evaluate Basel III liquidity risk ratios and BIS principles for sound liquidity risk
management.
 Explain liquidity black holes and identify the causes of positive feedback trading.
Explain and calculate liquidity trading risk via cost of liquidation and
liquidity-adjusted VaR (LVaR).
Cost of liquidation
Financial managers are often interested in what it would cost
to liquidate a book of assets. Measuring the cost of
liquidation is often the first method professionals turn to
when answering this question.
Suppose the difference between the asking price (offer
price) and the bid price for an asset is its spread, noted by s,
as shown below1.
= ( )−
The mid-market price is simply this equation divided by the mid-market price, as shown in the
following equation1.
−
=
−
The proportional bid-offer spread1, s, has a cost associated with it if a financial institution opts to
liquidate a position. That cost is equal to
= ∙
where is the value of the position measured in dollars. The above equation is the cost to
liquidate a position. If the financial institution wants to know what it would cost to liquidate an
entire book, the cost of liquidation is simply the sum of all the costs associated with each
individual position in the firm’s book, as indicated by the following equation,
=∑ (Eq 24.1)1
where N is the number of positions in the book. The above equation is the cost of liquidation
formula related to liquidity trading risk.
1 John C. Hull, Risk Management and Financial Institutions, 5th Edition (Hoboken, NJ: John Wiley & Sons, 2018).
Equation 24.1
3
Two important notes are relevant from the equation for the cost of liquidation.
 First, diversification may reduce market risk, it does not necessarily follow that it will
reduce liquidity trading risk2.
 Second, the spread, s, is affected by many factors, including the size of the book. As the
size of the book increases, the bid-offer spread generally increases. Why? Because a
concentrated portfolio with large amounts of only a few stocks is usually harder to unload
than a few shares of many stocks. As shown below3, the spread as a function of quantity
held. The spread widens as the quantity of the asset an investor is trying to sell
increases.
Example Bid-Offer Spread

$12.00
$11.00
$10.00
$9.00
$8.00 Offer price
$7.00 Bid price
$6.00
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Quantity Held of the Asset
An example of calculating the cost of liquidation4. Suppose that a financial institution holds
100 million shares of Company Gamma and 200 million ounces of a commodity. Further,
suppose that the bid price for the 100 million shares is $100 and the offer price is $100.50 and
the bid price for the commodity is $20 and an offer price of $20.10. The mid-market values for
the two positions are $10.025 billion and $4.010 billion, as shown in the following two equations.
$ . +$ .
− =( )∙ , ,
=$ , , ,
$ . +$ .
− =( )∙ , , =$ , , ,
2 John C. Hull, Risk Management and Financial Institutions, 5th Edition (Hoboken, NJ: John Wiley & Sons, 2018)
3 Variation of Hull’s Figure 24.1. John C. Hull, Risk Management and Financial Institutions, 5th Edition (Hoboken, NJ:
John Wiley & Sons, 2018)
4 Variation of Hull’s Example 24.1. John C. Hull, Risk Management and Financial Institutions, 5th Edition (Hoboken,
NJ: John Wiley & Sons, 2018)
4
From these, the proportional offer for the shares and commodities are5
100,000,000
ℎ = = 0.00998
10,025,000,000
200,000,000
= = 0.04988
4,010,000,000
With the proportional offers known, the cost of liquidation in a normal market is $105,011,875 for
a book value of $14,035,000,000, or 0.7% of the value of the book.
0.00998 0.04988
= 10,025,000,000 + 4,010,000,000
2 2
= $105,011,875.
Liquidity-adjusted VaR (the LVaR)

Another option for evaluating the liquidity of a book is the liquidity-adjusted VaR (or the LVaR).
The LVaR is used to calculate the liquidation cost when market conditions are stressed over
time. With and representing the mean and standard deviation, capturing the confidence
level for the spread, and captures the value of the ith position.
( )∙
( )= ∑ (Equation 24.2)5
The value is the deviate (aka, quantile) associated with the desired confidence level; in
practice, we assume a normal distribution. If the confidence level is 99.0% (aka, significance
level is 1.0%), then assuming normally distributed spreads, the = 2.326.6 For statisticians, the
2.326 should be familiar. It is the z-score, found using Excel’s NORMSINV function.
An example of the LVaR

Before calculating the LVaR, consider the calculation that comes before the LVaR calculation,
shown in the following table. Suppose a stock has a price per share of $48.00 per share.
Assuming 100,000 shares, the wealth of this position is $4.8 million. Next, assume that the
volatility of the position is 35.0% per annum, which is 2.20% on a daily basis assuming 252
trading days in a year7. With an expected return, µ, of 15.0% on an annual basis, the daily
expected return is +0.05952%. The normal deviate, α, for a 95.0% confidence level is 1.645
(found using Excel’s NORM.S.INV function). On a $4.8 million portfolio, the one-year value at
risk using a 95.0% confidence is $2,043,354 and the one-day value at risk is $171,218. These
figures are shown in the left pane of the following table. The right pane has the amount of risk
using a 99.0% confidence level.
6 Like VaR, this stressed spread always assumes a one-tailed deviate; i.e., at 99.0%, we use 2.36 and we do not
use 2.58, because only spread widening increases the cost.
7 The formula for conversion from annual volatility to daily volatility is = .
√
5
The VaR amount is now known. The next step is to calculate the LVaR. This is done at the
bottom of the following table assuming a 99.0% confidence level. Suppose the mean bid-ask
spread is $0.220 (0.458%). Further, assume that the spread volatility is 0.200%. Under these
assumptions, the worst expected spread is 0.92%, which is 0.458% plus the 0.200% multiplied
by 2.33 (remember, 99% confidence level). Next, to the actual LVaR calculation.
The liquidity cost (LC) with a static spread assuming equal half is 0.229% (0.5 times 0.458%).
The liquidity cost with a volatile spread is about twice as big at 0.462% (0.5 times (0.458% +
0.20% times 2.33)). In dollars, the liquidity cost using the static spread in this example is
$11,000, while the liquidity cost using the volatile spread is $22,166. This leads to the final
LVaR for the static spread of $3,199,264 and the final LVaR for the volatile spread at
$3,210,431.
6
7
Unwinding positions optimally

Finding the optimal way to unwind large positions is a challenging prospect for any financial
manager. The trader must weigh two options:
 If the trader opts to unwind a position quickly, he may face a large bid-ask spread but the
possibility of a loss from mid-market price movements may be small.
 If the trader opts to unwind a position slowly, the trader may face a narrower, more
desirable spread each day but runs the risk of larger losses from mid-market price
movements going against the trader’s position.
A formula for gauging optimal unwinding of positions. Is there a formula for the optimal
unwinding of positions? The answer is yes, and the following minimization formula captures one
such. First, start with the bid-offer spread costs, assumed below as half the bid-offer spread.
With representing the units traded on day i and ( ) representing dollars traded, the total
trade costs are the sum of the number of units sold multiplied by the associated with trading
those stock or bond units.
( )
∙
2
Next, suppose that mid-market changes are normally distributed with a standard deviation of
each day and that trading occurs at the beginning of each day. The total variance associated
with the trader’s position, assuming each day’s return is independent of the other, is, therefore,
the sum of ∙ , where is the initial position size8.
In this framework, the unwinding trader simply minimizes the VaR after trading costs. The formal
equation is to minimize the first equation subject to the second.
( )
∙ ∙ + ∙
2
Once one knows the coefficients and equations to plug into the above equations, then the
optimal trading strategy results.
Other measures of market liquidity

In addition to the cost of liquidation and the LVaR, other measures of liquidity include the
volume of trading per day, the price impact of a trade of a given size, and the ratio of absolute
value of daily return to daily dollar volume8. This latter measure, shown in the following
equation, is often used by financial researchers.
8
Identify liquidity funding risk, funding sources, and lessons learned

from real cases: Northern Rock, Ashanti Goldfields, and
Metallgesellschaft.
Liquidity funding risk
Financial institutions often make decisions that put them
at risk of being unable to finance their activities, such as
borrowing on the short-end of the yield curve and lending
out at the long-end. This structure, and other operational
management decisions, can sometimes create liquidity
funding problems. Common triggers for liquidity problems
include9:
 Stress in the economy: When the economy is
perceived as weak, investors become reticent to
provide finding when credit risk is any amount of
zero.
 Funding decisions that are aggressive:
Financial firms often use short-term instruments
to fund long-term demand, creating a mismatch in
liquidity. This liquidity mismatch can be a financial
institution’s downfall9.
 Financial performance that is inadequate: If
the market perceives poor management and
other operational mistakes, a financial firm may
be unable to attract deposits or roll over their
funding.
When companies experience liquidity problems, often all three factors are present.
Funding sources
Main sources of liquidity include the following six9:
1. Cash and Treasury securities: Cash is always liquid and Treasury securities can
usually be converted to cash on short notice without problems.
a. Advantage: Easy source of liquidity on a short timeframe
b. Disadvantage: Low return (expensive). For financial institutions to be profitable,
they much allocate their assets to higher-yielding loans, such as to corporations.
2. Ability to liquidate trading book positions: Banks hold some of their assets in their
trading book. When liquidity needs arise, the bank can sell trading book assets.
a. Advantage: Generally, earn a higher rate of return under normal market
conditions.
b. Disadvantage: Has a higher risk than cash and Treasury securities, and the
potential that the bank will be selling assets at undesirable prices due to stressed
market conditions.
9
3. Ability to borrow money on short notice: Banks must be well aware of the assets they
could use as collateral when loans are needed on short notice. In order to mitigate
potential funding risks during a liquidity crisis, banks typically arrange for lines of credit.
a. Advantages: Avoids holding assets in low-returning options such as Treasury
securities.
b. Disadvantage: During times of stress, the bank risks having its collateral assets
devaluated by the market and potentially being unable to access funding beyond
its lines of credit.
4. Ability to attract retail and wholesale deposits on short notice with favorable offer
terms: Banks can offer higher interest rates to depositors in an attempt to bring in more
retail and wholesale deposits.
a. Advantage: Potentially attracts capital that is sensitive to interest rate
movements.
b. Disadvantage: Typically, liquidity problems tend to occur simultaneously across
the entire market, affecting many banks at the same time. This means that when
a firm plans to attract capital by offering higher interest rates than other banks,
other banks are likely thinking the same thing.
5. Securitizing assets on short notice: Prior to August 2007, a significant source of
liquidity for banks was the originate-to-distribute model for such things as loans. Rather
than hold loans or mortgages on their balance sheets, banks securitized the assets and
sold them to investors. In a liquidity crisis, banks could securitize assets with investor
demand.
a. Advantage: Offers banks a source of funding on short-term notice while being
able to hold the assets on its balance sheet.
b. Disadvantage: If the market becomes too risk-averse or lack confidence in
certain assets that the bank had planned to securitize, this potential source of
short-term funding liquidity disappears.
6. Ability to borrow from the central bank: This is typically not the most desirable option
because central banks usually charge higher interest rates on short-term loans than
other options. Central banks also typically require a haircut on the pledged collateral (i.e.
the central bank often will not lend at the full value of the pledged assets). Still, should
liquidity become an issue, banks can typically borrow from their central banks. The rules
for borrowing from a country’s central bank differ. For instance, in August 2007, the
haircut required by the European Central Bank (ECB) was lower than what a bank would
have to take when borrowing from the Bank of England or the Federal Reserve. Many
banks considered (and some actually did) setting up operations in Ireland to take
advantage of the lower haircut offered by the ECB.
a. Advantage: A safe source of liquidity financing.
b. Disadvantage: Borrowing from the central bank can be more expensive.
Additionally, there is the risk of reputational loss when a bank borrows from a
central bank. The reason being is that the market typically considers borrowing
from a central bank as a last resort option (lender of last resort), and thereby
must be experiencing financial problems.
10
Lessons learned
Liquidity risk has led to the downfall of some of the world’s largest and respected financial
institutions, including, among others, Northern Rock, Ashanti Goldfields, and Metallgesellschaft.
Northern Rock10. One of the most famous examples of a financial
institution failing because of short-term liquidity problems was the
UK-based Northern Rock.
Up until its liquidity crisis in August 2007, Northern Rock had no
problems financing its large mortgage portfolio with wholesale
deposits and selling short-term debt instruments. Most of its funding
came from these two sources. But then came the global financial
crisis of which started in 2007. During this time, Northern Rock
couldn’t replace maturing financial instruments with new ones
because the crisis caused institutional investors to panic about the
potential credit risk associated with mortgage lenders.
Interestingly, Northern Rock was not short on assets that would
cover their liabilities. The Financial Services Authority (FSA) said as
such back in September 2007: “The FSA judges that Northern Rock
is solvent, exceeds its regulatory capital requirement, and has a
good quality loan book.10”
Even with this reassurance, when Robert Peston, who was the BBC business editor, revealed
that Northern Rock had borrowed from the Bank of England, Northern Rock experienced the
first bank run in England in 150 years10. From September 12th to the 17th, depositors withdrew
₤2 billion. By the end of the liquidity crisis, Northern Rock had borrowed an incredible ₤25 billion
from UK’s central bank. At that point (February 2008), the British government bought the bank
and removed management. Eventually, in November 2011, Northern Rock was purchased by
the Virgin Group for ₤747 million (led by Sir Richard Branson). This points to the importance of
managing the potential cascading effects of liquidity problems.
Ashanti Goldfields10. Another example of a company that
experienced liquidity problems was Ashanti Goldfields. The Ghana-
based company produced large amounts of the world’s gold supply
(it is still one of the top 10 gold producing mines in the world). As a
gold producer, Ashanti was concerned about the future price of gold.
To hedge its position, Ashanti worked with Goldman Sachs and
other investment banks to hedge its position in gold by selling gold
forward. Ashanti did this because they did not want their
shareholders to experience any adverse effects should the price of
gold decline.
The hedging backfired due to a lack of liquidity. In September 1999,
numerous European banks (fifteen in total) agreed that they would
reduce the sale of gold over the future span of five years. During this
time, gold prices increased more than 25%, which caused the
inability for Ashanti was unable to meet margin calls. This inability
led to a liquidity crisis at Ashanti. The gold producer was pushed to
the brink of bankruptcy, eventually selling a mine, diluting its equity
shareholders, going through major corporate restructuring, and
restructuring its “hedged” gold positions.
11
Metallgesellschaft11. A third well-known example of

liquidity problems is the German company
Metallgesellschaft. In 1993, Metallgesellschaft sold
substantial quantities of 5- to 10-year heating oil and
gasoline supply contracts for a fixed price that was six
to eight cents higher than the market price.
Metallgesellschaft hedged its position with long
positions in a short-dated futures contract that were
rolled forward11.
Surprisingly, oil prices dropped and Metallgesellschaft was faced with margin calls on its futures
positions. The position was made worse by others knowing that Metallgesellschaft’s positions
were substancial and highly expected by competitors.
The employees of Metallgesellschaft who executed the hedging strategy maintained that the
short-term cash outflows would be offset by the future positive cash flows from the long-term
fixed-price contracts11. Unfortunately for the employees, the company’s managers and bankers
had a greater concern for the short-term massive cash drain. Metallgesellschaft closed out all
hedged positions and the fixed-price contracts were stopped. This resulted in a tremendous loss
of $1.3 billion.
Both the Metallgesellschaft and Ashanti situations showed even in situations where the trades
are positive long-term, short-term cash flow liquidity issues can cause significant trouble for
companies.
Evaluate Basel III liquidity risk ratios and BIS principles for sound
liquidity risk management.
Basel III Liquidity Risk Ratio
Basel III introduced two new liquidity risk ratios:
 Liquidity coverage ratio (LCR): The LCR is the result of the high-quality liquid assets
divided by net cash outflows in a 30-day period. The Basel III committee required this to
be equal to or greater than 100%. The LCR was slowly increased to 100% from 60% in
2015.
( )= (LCR11)
The calculations for the 30 days include11:

o A downgrade of the high-quality liquid assets of three notches (for example, from
AA+ to A+)
o A partial withdrawal of deposits
o Full evaporation of wholesale funding
o Higher haircuts on secured funding
o Drawdowns on lines of credit11.
12
 Net stable funding ratio (NSFR): The NSFR shifts bank management’s attention to
liquidity management over one year. The ratio is simply the amount of stable funding
divided by the required amount of stable funding. The NSF should be above 100%.
( )= (NSFR12)
o Amount of stable funding: The numerator is simply the result of multiplying

each category of funding by the available stable funding factor (ASF), a measure
of stability12. The ASF factors are shown in the following table.
ASF Factors by Category13
Category ASF Factor
Tier 1 and Tier 2 capital 100%
Preferred stock and borrowing with a remaining maturity > 1 year 100%
Stable demand deposits and term deposits with a remaining 90%
maturity less than 1 year provided by retail or small business
Less stable demand deposits and term deposits with a remaining 80%
maturity of less than 1 year provided by retail or small business
Wholesale demand deposits and term deposits with a remaining 50%
maturity less than 1 year provided by non-financial corporates,
sovereigns, central banks, multilateral development banks, and
public-sector entities
All other liability and equity categories 0%
o Required amount of stable funding: The denominator stems from the items
requiring funding. Each category is multiplied by the required stable funding
(RSF) factor. The RSF factors are shown in the following table.
RSF Factors by Category13
Category RSF Factor
Cash 0%
Short-term instruments, securities, loans to financial entities if
they have a residual maturity of less than 1 year
Marketable securities with a residual maturity greater than 1 5%
year if they are claims on sovereign governments or similar
bodies with a 0% risk weight
Corporate bonds with a rating of AA- or higher and a residual 20%
maturity greater than 1 year
Claims on sovereign governments or similar bodies with a risk
weight of 20%
Gold, equity securities, bonds rated A+ to A- 50%
Residential mortgages 65%
Loans to retail and small business customers with a 85%
remaining maturity less than 1 year
All other assets 100%
12John C. Hull, Risk Management and Financial Institutions, 5th Edition (Hoboken, NJ: John Wiley & Sons, 2018)
13Adapted from John C. Hull, Risk Management and Financial Institutions, 5th Edition (Hoboken, NJ: John Wiley &
Sons, 2018)
13
 An example. As an example, consider the situation where a bank has the following
balance sheet. It has $1 billion in cash, $3 billion in Treasury bonds, $1 billion in
mortgages, $1 billion in small business loans, and $3 billion in fixed assets. On the
liability side, the bank has $40 billion in retail deposits, $48 billion in wholesale deposits,
$4 billion in Tier 2 capital, and $8 billion in Tier 1 capital.
o The amount of stable funding is $72.
40 ∙ 0.9 + 48 ∙ 0.5 + 4 ∙ 1 + 8 ∙ 1 = $72
o The amount required amount of stable funding is $74.25.
5 ∙ 0 + 5 ∙ 0.05 + 20 ∙ 0.65 + 60 ∙ 0.85 + 10 ∙ 1 = $74.25
o The NSFR is then 0.97, or 97%. In this example, the bank fails the NSFR
requirement of 100%.
72
= = = 0.97
74.25
Example of an NSFR Calculation

Asset Amount Liability Amount
Cash 1 Retail Deposits (stable) 40
Treasury Bonds 3 Wholesale Deposits 48
Mortgages 1 Tier 2 Capital 4
Small Business 1 Tier 1 Capital 8
Loans
Fixed Assets 3
Total 100 Total 100
BIS Principles for Sound Liquidity Risk Management

After the 2007 liquidity crisis, banking regulators released 17 general points of guidance on
sound liquidity risk management.
1. A bank takes self-responsibility for sound liquidity
risk management. The intent of this principle is that a
bank itself should be the first line of defense against
unsound liquidity practices, not regulators. A bank’s
liquidity risk management framework should be strong
enough to make sure there is adequate liquidity.
Stress testing should be robust should a bank
experience a loss in funding sources – both unsecured
and secured.
2. A bank should articulate its liquidity risk tolerance. A bank’s management should
ensure that its tolerance for liquidity risk tolerance is consistent the strategy of the
institution and the role it plays in the broader financial system.
3. Liquidity risk tolerance needs continual attention. Senior bank managers should
manage liquidity risk continuously to ensure the actual liquidity risk is in line with the
planned liquidity risk tolerance. Reports should be made by the bank’s senior
management to the board of directors regularly on developing liquidity issues.
14
4. New product approvals, internal pricing, and performance measurement should

incorporate liquidity costs, benefits, and risks14. By taking these steps, the bank
should be able to align their business line risk-taking incentives with their liquidity risk
exposure.
5. The control of liquidity risk should be a sensible process. A bank should be well-
aware and have a strong comprehensive cash flow management framework that is
associated with their assets, liabilities, and off-balance-sheet items.
6. Liquidity risk should be monitored regularly a bank should control their exposure
to liquidity risk. By actively monitoring and controlling liquidity risk exposure, a bank
should be aware of the funding needs across business lines, legal entities, and
currencies. A bank should also be aware of the how liquidity can be shifted across
operational units and the corporation as a whole.
7. Create a funding strategy with a variation of sources and funding. A bank should
have good relationships with fund providers and funding markets to ensure effective
variation in their funding suppliers. A bank must be ready on a dime’s notice to explain
its ability to quickly raise funds from identified sources. The bank should also be well
aware of anything that can influence their fund-raising capacity and continually make
sure that those factors continue to be valid.
8. Intraday liquidity positions should be actively managed and awareness of
payment/settlement commitments during normal/stressed market conditions. By
actively managing its intraday liquidity positions and other obligations, a bank should be
able to ensure that their systems for payments and settlement are functioning in an
efficient manner.
9. Actively managing collateral positions. Banks should always be aware of what their
encumbered and unencumbered assets are.
10. Stress test often. A bank should be intricately aware of potential stress, including short-
term stress stemming from the bank itself and the economy overall. The stress testing
should offer an idea of exposures and how certain stressing situations could cause the
bank to approach its maximum tolerance of liquidity risk. Stress testing should always
lead to action. This includes necessary changes to the bank’s strategy for liquidity risk
management and their policies.
11. Contingency funding plan (CFP). A bank should always make sure that there is a strict
contingency funding plan that has been approved by the board. This plan should
address steps and strategies in case a liquidity shortfall occurs during a crisis period.
The CFP should include ways the bank plans to address various stress environments,
including recovery and resolution procedures. The CFP should be tested regularly.
12. Retain a necessary amount of unencumbered liquid assets that are high quality. A
bank should have a sufficient supply of unencumbered, high-quality assets. This should
consider the fact that funding sources –unsecured and secured– could experience a loss
or very serious deficiency. The assets should be completely free of any legal, regulatory,
or operational weaknesses.
13. Be transparent. The condition of a bank’s liquidity position and framework should be
disclosed regularly – to the public – so that the market can judge the bank’s health.
15
14. Supervisors should perform assessments of a bank’s liquidity risk management

framework and liquidity positions on a regular basis15. By being ever aware of the
position the bank is in, supervisors will be more able to professionally manage a bank’s
resilience in stressed market conditions.
15. Supervisors should monitor internal reports, prudential reports, and market
information. In their role overseeing the functioning of the bank, supervisors should
consider important factors, such as then bank’s internal reporting system, including
internal reports, financial reports, and information about the market.
16. Supervisors should intercede quickly. When it appears that remedial action is needed
by the bank, supervisors should address the deficiencies promptly.
17. Communications with management or public authorities. Supervisors should be
good communicators, having good relationships with other bankers across multiple
geographic boundaries, including international boundaries. Supervisors should also be
well aware of when and who to talk to at their central bank.
Explain liquidity black holes and identify the causes of positive

feedback trading.
Liquidity Black Holes
In the past decades, the liquidity of financial markets has
been improved with the development of new technology.
Although the benefits of the increase in liquidity is hotly
debated among academics, there is no debate that the
bid-ask spreads have narrowed in recent years.
At the same time that liquidity has increased, there has
been an increasing, perhaps unnerving, rise in
“simultaneity trading”. Simultaneity trading refers to the
idea that there is a tendency for everyone to want to
make the same trade simultaneously. The situation is
now known as a liquidity black hole or a “crowded exit”15.
In liquidity black holes, price declines cause more traders
to sell. This pushes prices even lower, and causes
liquidity to dry up and then the asset can only be sold at
fire-sale prices.
16
Causes of Feedback Trading

Markets often trade with a healthy dose of a feedback loop, reflecting the behaviors of traders.
Generally, there are two types of traders – negative feedback traders and positive feedback
traders16.
 When prices decrease, negative feedback traders buy, and when the prices increase
they sell.
 When prices increase, positive feedback traders buy, and when the prices decrease
they sell.
At times, negative feedback traders control the trading activity, whereas, at other times, positive
feedback traders control the market’s movements.
 Negative feedback traders control market movements when markets are liquid. When
prices drop to theoretically unreasonable levels, negative feedback traders will buy the
stock. If the price moves above a reasonable valuation, then negative feedback traders
sell. The net result of the activity of negative feedback traders is a generally reasonable
balance between buyers and sellers.
 Positive feedback traders control market activity when trading becomes weighted and
relatively illiquid. When asset prices fall, positive feedback traders sell, causing prices to
fall even more. The same co-movement happens in the opposite direction. Essentially,
when positive feedback traders dominate market activity, market prices are generally
more volatile and illiquid.
17
Why positive feedback trading exists

Given the increase in volatility of asset prices, why does positive feedback trading exist? There
are at least seven causes for the feedback loop.
1. Trend trading. Perhaps the most influential factor behind
positive feedback trading loops is trend trading. Trend
trading captures instances when traders view the price of an
asset as trending up or trending down using such measures
as the 14-day or 365-day moving averages. Within the trend-
trading umbrella is breakout trading, which occurs when
investors consider a stock to have moved outside of its
targeted range. For instance, a trader might have the target
range for a given stock at $40 to $50 per share. When the
stock moves above $50, the trader may buy and when the
stock moves below $40 the trader may sell.
2. Stop-loss rules. Many investors used stop-loss rules when involved in equity investing.
A stop-loss strategy basically entails selling stock automatically when the stock’s price
falls below a specific price. Traders may opt for this strategy is they are concerned about
price drops precipitating further price drops.
3. Dynamic hedging. Traders, banks, and other financial entities often “hedge” their
positions with options. While there are options that have negative feedback, an example
of an option with a positive feedback loop is when a trader has a short position and buys
when the price rises and sells when the price falls.
4. Creating options synthetically. One of the more
sophisticated options investors take is to create
options synthetically. Firms involved in synthetically
creating options know that hedging a short position in
an option is the same thing as synthetically creating
a long position in the same option (i.e. two negatives
equal a positive).
Professional investors can also create long option
positions synthetically by performing the same type
of trades as it does if the firm hedges a short
position. This can lead to a strong positive feedback loop associated with market
instability and illiquidity17.
Perhaps the most famous case in point is the 1987 stock market crash, known as “Black
Monday the 2nd”. The drop was the largest single one-day drop in the stock market in
U.S. history. Before this drop, the market had been performing well. Portfolio managers
would use commercial programs to synthetically create put options (the right to buy a
stock at a given price in the future). The programs directed that the managers should
buy a stock when the price increased and sell the stock when the price dropped. The
strategy worked well until it led to a deep liquidity black hole17. Fortunately for equity
investors, the market drop was short-lived, with the market making up almost all of its
lost value after about four months of trading.
18
5. Margins. When markets move “big”, it can often lead to massive unrealized gains or
losses for investors that are heavily margined. When markets experience a big move
that is opposite of what a given investor was expecting, it can lead to a margin call.
When faced with margin calls, investors are forced to sell leveraged positions at large
losses, which can reinforce market volatility. The situation is further exacerbated by
exchanges responding to increasing volatility by increasing market requirements. The
positive feedback loop continues until it is broken.
6. Predatory trading. Trading is partly a zero-sum game. If a trader knows of an entity that
will have to sell a substantial portion of stock, then they will know that there will be a
drop in the price of that stock. To profit off this anticipated price drop, an investor may
take a short position, which reinforces the anticipated price decline. This type of
predatory trading often means that institutions may need to unwind large positions slowly
over time or use other discrete trading entities to accomplish unloading the position.
LTCM. One of the famous examples of positive
feedback trading destroying a fund is Long Term
Capital Management (LTCM). Perhaps the reason the
LTCM failure is so famous is that it was founded by
Nobel Prize-winning economists and other well-known
financiers. They built elegant mathematical models to
theoretically show the advantage of their trading
strategy. The strategy worked for a while. A popular
trading strategy was “relative value fixed income”.
This trading strategy involved shorting a liquid bond
and going long a similar bond that was illiquid. The
fund would then wait until the prices moved closer
together. What went wrong? In 1998, Russia
experienced financial turmoil and defaulted on its
bonds. This default had the effect of lowering the
value of illiquid instruments comparative to liquid
instruments that were analogous and caused massive
unrealized losses at LTCM. The problem was that
LTCM was severely leveraged and they were not able
to meet their margin calls. As a result, LTCM was forced to liquidate its positions. This
involved purchasing the securities they were short (the short-term liquid bonds) and
selling the long-term illiquid bonds, essentially buying high and selling low. This
leverage-driven requirement led to a further flight to quality18 and further divergence in
price, with the liquid bonds increasing in price and the illiquid bonds decreasing in value.
As is often the case, black swan events can lead to strong positive feedback loops.
7. Leveraging and Deleveraging. Positive feedback also stems from the cycles of
leveraging and deleveraging, depicted below. The first figure is the leveraging process.
When times are good, banks are often awash in liquidity, and credit spreads tighten.
Investors are allowed to increase leverage. In response to the increase in leverage,
investors buy more assets. In response, asset prices increase. When the increase in
asset prices is “sufficient enough”, the leverage of investors decreases. The positive
feedback loop then starts again until the “bubble” pops.
19
Leveraging and Deleveraging Cycles19
The deleveraging process is similar. When economic times are tough, credit spreads widen and
banks are less willing to lend, especially on margin. As a result, investors must decrease
leverage by selling assets. As a result, asset prices decline. When the decrease in asset prices
is “sufficient enough”, the leverage of investors increases. The process then starts again until
the asset markets reach an overall bottom.
19 Both diagrams on this page were adapted from John C. Hull, Risk Management and Financial Institutions, 5th
Edition (Hoboken, NJ: John Wiley & Sons, 2018)
20
Irrational Exuberance
The phrase “irrational exuberance” was first coined by former Federal Reserve chairman and
world-renowned economist Alan Greenspan in a December 1996 speech. He was originally
referring to equity markets, when he asked, “How do we know when irrational exuberance has
unduly escalated asset values?”20 The comment sparked a hotly contested debate in the
economics world between behavioral economists and efficient market hypothesis theorists.
On the one side of the debate are economists, such as Alan
Greenspan, who argue that markets are not as “efficient” as
some economists portray them to be. They argue that
investors have many psychological biases, such as
anchoring bias, risk aversion, herd following behavior
(bandwagon effect), attribute substitution bias, backfire
effect, framing effect, among many others. A well-known
quote from the ex-CEO of one of the largest banks in the
world sums up the business response to the behavioral
economics point of view21:
“When the music stops, in terms of liquidity, things will be
complicated. But as long as the music is playing, you’ve got
to get up and dance. We’re still dancing.”
On the other side of the debate are efficient market
hypothesists, who argue that markets simply incorporate all
available information at any given time. When markets
experience large swings in volatility, it is because new
information became available, not because traders
somehow behaved as crazed lunatics one minute and
switched the next.
The debate often comes down to one’s view on what causes bubbles. Is it irrational behavior on
behalf of market participants or does it stem from information changes? Likely the debate will
never be resolved because the two sides are really just framing the conservation through
alternative lenses. In any event, some of the most well-known “bubbles” that behavioral
economists mention are the 1987 stock market collapse, the 1994 bond market crash, the 1997-
1998 Asian financial crisis, the 1998 Long-Term Capital Management failure, and the 2007-
2008 subprime mortgage crisis20.
21 Chuck Prince, ex-CEO of Citigroup (July 2007)
21
Regulation. As is often the case, regulation plays an important role in financial market liquidity.
In the past two decades, financial regulators have worked to make regulations consistent across
countries. This move towards consistency comes with drawbacks.
 First, uniform regulations tend to force banks to react in a similar way to external
events22. This homogeneous behavior may lead to similar risk profiles, positions, and
trades, which may result in a liquidity black hole – greater volatility and systemic risk
rather than less.
 Second, the push towards uniform regulation has pushed credit into a black hole-like
situation. When the economy is at its bottom, default probabilities are high and loan
capital requirements tend to be high22. Banks are less likely to provide loans to small and
mid-sized businesses, the opposite of what a regulator would want. Similarly, when the
economy is booming, default probabilities tend to be low and banks are more interested
in providing loans. This procyclical nature of lending stemming partially from regulation
was noticed by the Basel Committee and has been somewhat addressed. Rather than
using current period default probabilities, banks use the average default probability
across the business cycle to estimate required reserves.
Diversity. Generally, economic models assume

individuals (traders) act independently. This is
sometimes the case, but often not, especially in financial
market trading. Rather than acting independently, traders
often move in herds, and this herd behavior leads to
liquidity black holes. This is even more so for employees
of financial firms – they often want to make equal trades
as other traders. This lack of diversity (in a sense) has
led to many proposed solutions. Creating diversity is one
solution to help regulate financial firms differently. For
instance, hedge funds have different risk profiles than
banks or insurance companies22, and as such should be
subject to a different set of regulations (as they already
are). The issue of diversity in financial trading makes the
case for contrarian investment strategies, among other
things. Opting for a contrarian trading strategy is more
difficult for large financial institutions because they are
subject to short-term VaR-based risk adjustments22. In
any event, diversity is an important aspect of liquidity
(and lack thereof) in financial market price movements,
and will likely always be an issue.
22

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P2.T8. Liquidity and Treasury Risk Measurement and

John C. Hull, Risk Management and Financial

Bionic Turtle FRM Study Notes

Hull, Chapter 24: Liquidity Risk

Hull, Chapter 24: Liquidity Risk

Example Bid-Offer Spread

NJ: John Wiley & Sons, 2018)

Liquidity-adjusted VaR (the LVaR)

An example of the LVaR

Unwinding positions optimally

Other measures of market liquidity

Identify liquidity funding risk, funding sources, and lessons learned

Metallgesellschaft11. A third well-known example of

The calculations for the 30 days include11:

o Amount of stable funding: The numerator is simply the result of multiplying

Example of an NSFR Calculation

BIS Principles for Sound Liquidity Risk Management

4. New product approvals, internal pricing, and performance measurement should

14. Supervisors should perform assessments of a bank’s liquidity risk management

Explain liquidity black holes and identify the causes of positive

Causes of Feedback Trading

Why positive feedback trading exists

Leveraging and Deleveraging Cycles19

Edition (Hoboken, NJ: John Wiley & Sons, 2018)

Diversity. Generally, economic models assume

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