Lost in the fog: explaining weird market events

Financial markets can look deceptively healthy - liquid, orderly and deep - right up until the moment they aren’t.

The 2010 ‘Flash Crash’ briefly wiped nearly a trillion dollars off US equity valuations in minutes. Four years later, US Treasury yields spent an unpleasant day oscillating wildly for no apparent reason. In March 2020, even the world’s most liquid market - US government bonds - briefly seized up.

Each time, investors found that liquidity had evaporated just when they needed it most.

Such events are usually put down to balance-sheet constraints, 'information asymmetries' or regulatory 'frictions'. These matter. But the real culprit is opacity - the inability of market participants to see what others are doing. When this fog reaches a certain level, fragility stops being possible and becomes inevitable.

A warning from the bond market

Another mystifying incident from the US government bond markets, the 2013 'taper tantrum' is instructive. When the Federal Reserve signalled it might unwind its bond-buying programme, firms that collect monthly payments on home loans - mortgage servicers - found their asset values rising sharply. That's because higher rates slow early repayments and extend their income streams. Risk management rules required them to hedge that windfall by selling government bonds.

With thousands of servicers acting on the same signal at once, a wave of selling hit the Treasury market. Nobody could tell how much forced selling remained in the pipeline. Bargain-hunters held back or added to the pressure. Yields overshot dramatically, tightening financial conditions far more abruptly than the Fed had intended.

The problem was not a shortage of capital: potential buyers simply could not see what was driving the market.

The new liquidity providers - and their limits

Liquidity increasingly comes from discretionary participants: hedge funds taking contrarian positions, high-frequency traders posting prices, and portfolio managers willing to act as counterparties when prices overshoot. Unlike designated market-makers - who are bound by formal obligations to quote prices in good conditions and bad - these players are fair-weather suppliers. They step in when it pays and step out when it doesn’t.

Their willingness to provide liquidity depends critically on what they can infer about who else is trading. In transparent markets, a trader can often conclude that a decline is about to reverse - and profit by stepping in.

Opacity destroys this signal. Unable to read whether selling reflects genuine shifts or mechanical rebalancing needs, discretionary traders fall back on noisy private signals, injecting additional noise when markets are most stressed.

This makes execution unpredictable for investors who must trade, driving them to scale back - at which point the mechanism turns cruel: as those investors retreat, conditions improve for discretionary traders, who step in more aggressively. The retreat of the cautious is the cue for the bold to advance, in a cycle that leaves markets simultaneously quieter and more fragile.

When selling pressure is heavy, dealers absorb what the market is trying to offload - and the larger that pile grows, the more exposed they are to prices falling further before they can find buyers on the other side. They demand higher margins in return.

The very investors who most urgently need to trade end up facing the worst conditions - the inverse of how liquid markets should work.

Carefully designed transparency helps, but regulators need to strike a balance: improve the information available to discretionary suppliers without giving predatory traders a window into others’ positions.

What is to be done?

Several live policy debates are relevant. Wider dissemination of post-trade data for Treasuries - modelled on TRACE reporting in corporate bonds - could have moderated the taper tantrum and would reduce similar risks in future. The Securities and Exchange Commission’s proposed dealer registration rule, which would extend regulated status to high-frequency traders, would limit their ability to withdraw strategically - though at the cost of higher participation costs and potentially thinner markets.

And the consolidated tape arriving in the UK for bonds in June, and soon after in the EU, will directly reduce opacity - a concrete rationale for reforms too often justified on vaguer grounds.

The standard toolkit for dealing with market stress - circuit breakers, leverage caps, mandated market-making - addresses symptoms rather than the underlying fragility. It is not excessive leverage or insufficient capital that renders modern markets structurally vulnerable: it is the fog enveloping discretionary suppliers.

Lift that fog with well-targeted transparency measures, and you strangle at birth the self-reinforcing dynamic that turns a manageable shock into a crisis.