Liquidity - Why you may not have as much as you think
It's all about liquidity. With it you have a fighting chance. Without it you are on course to ruin.
In this post we are going to speak about liquidity from the perspective of an investor and a business. The stories will give you a clear idea of when and why liquidity matters.
Definition of Liquidity
The Oxford English Dictionary spells out the definition of liquidity as:
The availability of liquid assets to a market or company.
The secondary definition(s) cover things from a business view:
Liquid assets or cash
and then as an investor:
A high volume of activity in a market
The nuance in definition(s) is subtle but important. Please keep them in mind as we walk through examples of how and why liquidity matters.
Twitter Investors Get Rocked
This story comes from the misadventures in my 30 years as an investor. Since it happened, I always keep one eye focused on investment liquidity.
On April 28th 2015 Twitter was set for a routine earnings announcement. The company was young and earnings were erratic. But what happened next was a shock.
With roughly 1 hour before the scheduled announcement things went haywire. The Nasdaq unit Shareholder.com released the earnings data early by 45 seconds. Once that got out all hell broke loose. Bloomberg, CNBC and online sources ran with the data and the stock came under immediate selling pressure.
-3%, -5%, -7% - TRADING HALT!
The pause in trading was only a brief reprieve. The question then became - when it reopens where will it be? This is where liquidity comes into play. That initial 10% cut to my position stung. But I also knew that the buyers who absorbed that initial selling may not be there when it starts trading again. When a trading halt on a stock happens it is usually due to some extreme event. The idea is to pause trading so both buyers and sellers can absorb the news, take a breath, and decide their next move.
Trade resumes after buyers and sellers place orders where they want to transact. In the old days that would be face to face in the pits. Now it happens on electronic order books. In this situation - unfortunately for me - the buyers disappeared. With a 10% downside move already registered. The buyers threw their hands in the air and only "cared" at -20%! Twitter reopened -20% and ended the day -18%. The next day it was down another -8%. Close to a -30% haircut in two days!
Over the next year Twitter traded as low at $14 in May 2016.
This may come across as an extreme example. But events happen and you never know when liquidity will disappear. What usually was an actively traded and deep market for Twitter evaporated and left me and other investors down the mineshaft. My hope is this story plants the seed that no matter what investment you make. It is only worth what a buyer will pay for it when you need to sell it. If you find a buyer at all.
Robinhood's Near Collapse
With Robinhood and the meme stock rally fresh in everyone's mind, I want to explain how a liquidity crunch almost rendered Robinhood insolvent.
When you buy stocks with a broker like Robinhood, clicking the buy button may make it seem like you own the stock instantly. That is actually not true. The process of sending your order, seeing it as filled, and then owning the stock has a process. It looks like this.
First you input your buy order and hit "send". The order goes to the broker OMS (order management system). The OMS then shoots your order out to the exchanges (NYSE, Nasdaq, etc.) and broker dealer network. After the buyer and seller match - the app reflects you as an owner. All of this happens in a matter of seconds.
What the above process does not account for is the process of settlement.
Settlement is the full transaction process. From order completion to the transfer of money from your account to that of the stock seller.
The entity that handles this is the DTCC. The DTCC acts as the middleman or custodian to make sure the transactions happen as expected. Stocks settle on T+2 (trade date + 2 days). That means there is a two day window from order execution to the DTCC sending cash and securities to the respective brokers. The cash the DTCC holds comes from your broker. This is to cover ALL unsettled transactions in a particular company. You can think of it like an escrow account.
The DTCC also determines the margin requirements on stocks. Brokerage clearing firms then use this data to determine how much a broker needs to hold on deposit. The actual stock brokers also use the data to determine how much a customer needs in order to make a stock purchase. When stock prices become volatile, DTCC can increase the amount brokers need to hold with them. This is what happened with GameStop (GME) and AMC Theaters (AMC).
Robinhood is a self clearing broker which puts extra pressure on them to have required deposits in place. This is how Robinhood got tripped up.
Robinhood's risk model calculating outstanding transactions, stock volatility, and clearing firm requirements was off. This meant that when transaction volume swelled along with stock price volatility. The DTCC came knocking asking for an increase in cash deposits to cover unsettled trades. The amount required was more than Robinhood had so they needed to do two things.
- Restrict buying of the meme stocks because they did not have cash to cover unsettled trades
- Find cash to plug the funding requirements they could not meet
Luckily for Robinhood they have deep pocketed investors and bank lines of credit they could turn to for liquidity. Robinhood raised over $3 billion in funding to meet their clearing requirements over a few days. If they did not meet the clearing requirements. They would have had to force liquidate customer positions. Or worse - shutter Robinhood, the company itself.
Robinhood CEO Vlad Tenev tried to downplay the situation. But one has to assume there was a moment when he felt the ship was going down. The Robinhood risk management team is on the hook for this one. It is their job to make sure things like this do not happen. But they failed.
It is worth restating that Robinhood’s restriction of certain stocks was not evil. It was a move to make sure their company survived because they did not have liquidity to cover the margin call they got from DTCC.
The stories in this post are only two examples out of many that center around liquidity.
There are numerous stories about companies facing liquidity crunches. From companies not being able to pay suppliers. To companies going completely insolvent. It all revolves around liquidity.
As cash managers for companies we are hyper aware of the importance of liquidity. These stories should be a warning shot to readers. Please make sure you understand where you stand with your liquidity.
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