Are We on the Verge of a Liquidity Crisis?

His concern comes from a provision contained in the recently passed H.R. 83, the “Consolidated and Further Continuing Appropriations Act of 2015.” In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires that traditional banks conduct their derivatives trading via special subsidiaries, unprotected by the FDIC. Since Dodd-Frank, banks have sought to change that provision so they can use deposits to underwrite some of their more complex derivatives trades. According to some, H.R. 83 has rolled back that provision. Apparently, this is only partly true as banks will still have to spin off their more complex derivatives strategies.

Sprott has another concern. Because these banks are not required to mark to market, no one really knows what these assets are worth. As a result, the one-quadrillion dollar derivatives market poses a huge risk. But how does he knows the derivatives market’s value if we don’t know the value of the underlying investments? In any event, we can surmise that the derivatives market is substantial. His biggest fear? “Someday there is going to be a claim on some entity where that bank will not be able to honor the claim.”

Liquidity Trouble Ahead?

New York University economist Nouriel Robini believes there is a “liquidity time bomb” which will eventually “trigger a bust and a collapse.” As evidence of this, he cites the 2010 flash crash, the Fed “taper tantrum” in the spring of 2013, and a flash crash in the bond market in the fall of 2014. One official from the New York Fed even said reduced liquidity may have played a role in that last case. Roubini said there has been an upsurge in “lightning fast trades” which has led to an increase in herding behavior and crowded trades. “As more investors pile into overvalued, increasingly illiquid assets — such as bonds — the risk of a long-term crash increases,” he concludes. Hence his comment that market illiquidity will eventually trigger a bust and collapse.

The 2000s have not been an easy time for investors. We’ve had at least two bubbles plus a coordinated monetary/liquidity expansion from many of the world’s central banks. Roubini says there’ll be more flash crashes in the days ahead. If so, then perhaps Eric Sprott’s earthquake-tsunami analogy is worth considering. Especially since we’ve never been at a place quite like this in the history of the financial markets.

To clarify, there’s never been a time in history when so many central banks have expanded the amount of liquidity in the system at the same time. Perhaps Roubini is correct. Perhaps there really is a liquidity time bomb ticking. Tick, tick, tick…..