Newsmakers

Wall Street’s wild ride and “liquidity black holes”

By Professor Andrew Karolyi

Andrew Karolyi’s Reutersfueled comments on the frenetic ups and downs of Wall Street and his upcoming research washed the world-wide media last summer. Karolyi, co-academic director for Johnson’s Emerging Markets Institute and professor of asset management and finance, spoke to Reuters in “Insight: The Madness of Wall Street” (Aug. 19), saying: “We have to be aware that we can be hit by one of these liquidity black holes with ever-increasing frequency. If you are a long-term buy-and-hold investor you better be aware of these and not panic when you see it.” Karolyi said that the waves of wholesale selling driven by liquidity black holes are not just the byproduct of the overcomputerization of trading; it’s the end result of too much “groupthink” by institutional traders.

Karolyi says Wall Street first saw this in August 2007, when dozens of quant hedge funds suffered big losses at the start of the financial crisis because the algorithms they employed were all buying and selling the same securities. This flawed thinking by some of Wall Street’s brightest math geeks was an early warning sign of even worse group think to come with regards to the value of securities backed by subprime mortgages.

Karolyi says his research, which will be officially published later this year in The Journal of Financial Economics, has found the phenomenon of liquidity black holes is spreading beyond the U.S. to other stock markets. That is problematic because the effects of liquidity black holes can be profound.