From Storms to Floods: Adapting to shifting liquidity sources in a volatile market
Over the past couple of weeks, we’ve all seen the business headlines – eye-popping metrics around the severity of the sell-off and the power around it, harkening back to historical market events such as: Covid, Volmageddon, Flash Crash, and the Global Financial Crisis of 2008. One large difference between now and those earlier events is the make-up of market volumes and the sources of liquidity. The biggest structural change coming out of Covid was the secular shift from on-exchange traded dominance to a more balanced mix of off-exchange traded volume to on-exchange – a measure garnering much attention in recent months as for the first time, the off-exchange traded percentage of total market volumes surpassed 50% and had some staying power. There are five components that make up what is reported as “off exchange”, or FINRA TRF, and as market conditions change as quickly as we have seen over the course of the first quarter of 2025, the ebb and flow of those components will shift just as rapidly. Understanding these components goes a long way to better understanding trading conditions. Sometimes, just like a bowl of Jello, if you push down on one side of the bowl, the other rises. On the other hand, where some of these volumes are being executed, it can be clouded.
2024 Off-Exchange Components and Percentages of the FINRA TRF-reported (approximates):
Retail/Wholesaler: 37%
ATSs: 25.5%
Capital Commitment/Upstairs Blocks: 23.5%
Single Dealer Platforms: 10.4%
Closing Auction: 3.6%
2024 Off-Exchange Components and Percentages of the Total Consolidated Volume (approximates):
Retail/Wholesaler: 17.2%
ATSs: 12%
Capital Commitment/Upstairs Blocks: 9.5%
Single Dealer Platforms: 4.5%
Closing Auction: 1.8%
The four trading days following Trump’s tariff announcements on April 5 will go down as the heaviest volume the market has ever seen. Some of the aforementioned historical volumes came at times when the market was struggling to trade 7 – 8 billion shares daily. We saw a remarkable acceleration of volume in a relatively short period of time, however, the “simpler” times preceded the advent of such phenomena as PFOF, ETFs garnering 40%+ of total market volume, and perhaps most importantly, the evolution of electronic market making. In itself, electronic market making has evolved from the most esoteric corners of the market, utilizing a technology arms race to take advantage of spread opportunity and market signaling, all the way to what now is very much a symbiotic relationship with both the buy-side and sell-side as a legitimate source of liquidity – if the conditions and trading tactic are right.
Shifting liquidity sources: The metrics that matter
To begin with, the investment banking reported volume is a worthwhile data point to track. There was a time where most of the liquidity in the market was sourced from the large investment banks and their execution of institutional flow. This is the type of flow that is most attractive to traditional asset managers as it creates real depth while bringing balance and realistic expectations around expected impact cost of a trade. In more docile conditions, it creates block appetite. Although this volume does still exist, over time it has grown to garner a much smaller percentage of overall volumes. The 3.82 billion shares of investment bank volumes reported on April 4 was the type of rarified air reserved for a Russell Rebalance day or major MSCI reconstitution, and excluding those events, was the heaviest going back to the summer of 2020. This culminated in the worst two-day sell-off of equities since that timeframe and served as a notch in the belt for the capitulation seeker. Total market volume on April 7 was higher but the investment bank reported volume dropped 20%, and then down 28% through the next day.
In a less fragmented world than what we’re seeing today – when executable, institutional volume, was more prevalent in the marketplace – a trader could have a better understanding of their contra. We saw this in 2024, which resulted to the best trading conditions of the past ten years, fueled by low correlations, low real price volatility, high visibility into earnings delivery and macro certainty – all amounting to better depth of book and lower trade costs. Since then, we’ve taken a complete 180 degree turn in an incredibly short period of time. The block metrics are sub-components of the five off-exchange categories listed above, and can be hidden as well, but lay within the ATS and OTC upstairs segments. Those categories showed some of the better growth in 2024 as block appetite grew but overall that part of the market has decelerated over the past ten years. When conditions are docile like 2024 with an over-deployment of cash concentrated to the U.S. market, the way in which traders get into their positions is much different than how they get out. This is particularly evident in a high conviction, volatility driven, sell-off like we’ve just seen.
When mentioning best conditions, it is not in terms of equity performance but rather standards that lower expected impact costs – i.e. high depth, lower spreads, and block appetite. Those conditions, however, generally go along with a rising equity market and with that comes retail-chasing performance. The retail/wholesaler segment is the largest of the TRF measures and when the market turns as it has, that segment will dry up quickly – from 20% of total market volumes when things are smooth, to the low teens when things are downright abrasive. This combined with widening spreads and more urgency in trading, is leading to a move away from dark trading and directly to exchanges. The anomaly dips here are around rebalances where closing auction activity on exchanges are high but the dip we saw over the first week of April will diminish some of the business headlines looking for answers as to why 50%+ of market volumes are happening off-exchange.
Correlations are a key factor in the active manager’s turnover or continuous volume in the marketplace. Due to the re-introduction of volatility, April 8’s 1.5% (final) move in the S&P 500 equated to only .8 standard deviation. Over the course of 2024, that type of move would have been closer to 2. The year 2022 was one of high volatility – not necessarily as measured by traditional volatility reading like the VIX but because of the real and implied price volatility, which was arguably higher than when Covid-dominated 2020, just because of the sustainability. Correlations peaked and stayed at historical highs in an abnormal way. Correlational valley and peaks are often a precursor of a turn in the market. While a better backdrop for the stock-picking asset manager, 2024 likely stayed at historical lows for too long. Low correlations suggest three things:
Lessening macro-risk
Better stock-picking environment
Growing overall risk (overbought and overstretched sentiment)
Eye SPY a market full of fear
While it doesn’t feel like it, risk is leaving the room quickly, as indicated by a simple S&P 500 3M Realized Correlation. This brings us to SPY volumes as a barometer of market fear, just by the sheer size of the AUM but maybe most importantly, the unprecedented notional value of the daily trading activity. It is the mother of all ETFs with the liquidity it provides, the immediate market exposure, and the breadth of usage across all investor types – i.e. institutions, traders, hedge funds, advisors, individual investors, etc.
The average daily SPY notional over the course of 2024 was $30 billion shares. April 7 saw a record $129 billion notional traded, indicating there is some real fear. Even though ’24 was extremely calm and orderly trading, the clustering of SPY notional over the course of the year shows pivots in direction (notional was 50% better than average and the start of a new V-shaped springboard or mis-direction), particularly as unease started to emerge at the tag-ends of the year, starting with the federal government’s pivot in message mid-December.
Significant bursts of activity in SPY tend to happen near market bottoms and to go along with this as a measure of market fear, ETF activity can do the same. ETF growth across the board is a major theme, with the ETF industry currently representing $7+ trillion in assets, where 60-70% of the ownership is held by retail. The highest range of activity, or ETF trading as a percentage of total market volumes, is 40%. On April 4, US-listed ETFs traded a single day record of $535 billion only to be topped on Monday, April 7 with $641 billion. This makes sense since of the most liquid ETFs – i.e. SPY, QQQ, IWM, TQQQ, IVV, HYG – it provides the type of market exposure or hedge that single positions would be difficult to do. Coupling the level of SPY trading with the record-setting ETF activity, along with a VIX reading of 60+ and it’s another notch towards the capitulation seekers.
Adaptability is the name of the game
There are three conditions that prevail when volatility picks up:
Dark trading drops: A market dominated by market makers who are skipping dark to get directly to the market
Average trade size drops: Adverse selection fears were exacerbated
Spreads rise: When volatile, market maker quoting gets wider to compensate for risk
These measurements are moving with alarming enthusiasm. Spreads, depth, and expected impact costs are creating an uneasy situation for buyside traders, as well as brokers trying to provide execution quality. The tactics and urgency for trading have to adapt to the liquidity sources, which are evolving just as quickly. Spreads are going parabolic, while book depth is getting totally depleted. Risk variance is hitting extremes, particularly as traders move to schedule-based or POV style trading – a natural callus against the fear of adverse selection. Risk variance, however, is best combatted by the large price-in-time trade. While that type of conviction is not for the faint of heart, it creates incredible alpha capture opportunity in this environment.
A recent conversation with a seasoned head trader at a large investment manager, with 25 years of experience handling all of the historical moments mentioned above, was enlightening. In the early hours of Monday morning, with a pad loading up with portfolio manager sell orders, and US futures indicating down 10% and APAC hitting trading halts – this is the time to lean back on experience and wisdom. A lot depends on your firm – a high turnover hedge fund or a large long-only, is de-risk pedal-to-the metal and smashing bids the only option? Of course, sometimes it is and sometimes it isn’t. Be aware, however, that while in the throes of the volatility, it feels like the world is ending but these types of situations have historical precedence, and in particular, this doesn’t feel as violent as the period during Covid. The market historically averages a correction every six years and the S&P 500 stands some 120% higher than the levels during Covid. Conditions since then have changed significantly, particularly the sourcing of liquidity and trading conditions. Volatility will subside, likely leaving a fog of uncertainty that will be tough for the sun to break through this calendar year – and traders will have to adapt.
Written by Jeffrey O’Connor, Head of Equity Market Structure and Sell Side ATS Strategy, Americas
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