• The recent stock market correction was worsened by a flash crash in illiquid investment products that had bet on low volatility.
  • This flash crash and others during the recovery have occurred against the backdrop of a relatively good economy — and that’s the worrying scenario, according to Charles Himmelberg, Goldman Sachs’ cohead of global markets research.
  • If such a drop happens as investors digest sour economic news, that’s when we could see a spillover into the real economy, he said.

The factor that triggered the most recent major meltdown in financial markets is unlikely to cause the next, according to Goldman Sachs’ Charles Himmelberg.

Himmelberg, the bank’s cohead of global markets research, thinks “liquidity is the new leverage.”

In a nutshell, “leverage” refers to investment products that were backed by bad mortgages, which played a major role in deepening the 2008 crisis. At the time, investment banks took on excessive debt to support their portfolios and increase the chances of a higher return.

Today, investors are increasingly embracing illiquid products in their quest for higher yields. The exchange-traded notes that had profited from the stock market’s low volatility before the flash crash in February are a good example, Himmelberg said. When the Cboe Volatility index, or VIX, had its biggest one-day spike ever, traders who owned these ETNs were forced to cover their short bets in a virtually one-directional trade.

“A scenario worth worrying about is that every flash crash so far has been against the [macroeconomic] backdrop of ‘things were good,'” Himmelberg said at a conference on Wednesday.

Wage growth and concerns about higher interest rates, for example, were the driving narratives behind the market’s correction in February. But Himmelberg doesn’t think this holds water, since year-on-year average hourly earnings have been growing at a steady pace since last October.

“What if one of these flash crashes happens when there is macro news to be worried about, when we are in the middle of a trade war, let’s say,” Himmelberg said.

“If there’s real macro news that’s already in the market and then we get big price moves, the market would say, ‘Well, that just proves it.'” Such a move could be big enough that it begins to feed into the real economy, Himmelberg added.

Electronic trading could also drain liquidity during a crash that happens against the backdrop of bad economic news, Himmelberg said. In some cases, such programs are designed to shut down as a fail-safe mechanism against massive losses.

The risk lies with products in which a wave of selling forces more selling and necessitates a trade that hedges against further losses; in the case of the VIX-linked ETNs, it was buying more volatility, Himmelberg said.

Exchange-traded funds broadly do not fit this bill, he noted. “The biggest product innovation of this cycle has been ETFs,” he said. “By and large, they do not force selling in a downturn.”

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