Market professionals understand that crashes are caused by a liquidity crisis. From a global perspective, we have the beginning of a liquidity crisis that appears to be similar to 2008 in some ways.
On a small level, when positions start going against a leveraged trader they either have to add money to their account or sell. Leverage indicates they don't have money to add to their positions. Since markets are already moving against them, selling large positions will increase the amount of the loss.
When a number of traders are using the same strategy, as they did with portfolio insurance in 1987 or mortgage derivatives in 2007, the crash can impact the entire financial system.
In the past week, a liquidity crisis has been unfolding in China. The rate on short-term bank loans has surged to all-time highs.
Pimco Chief Executive Officer Mohamed El-Erian has noted that short-term rates are "the most critical indicators of distress" that will come from the markets.
During the crisis related to the U.S. debt ceiling debacle in July 2011, El-Erian told Bloomberg, "That's the very first thing I do now is I go over to our money market desk and ask them, 'What you are seeing today? How's the repo market operating? Because that is what can really trip an economy."
If China is at the beginning of a crisis, it could be the tip of the iceberg. Credit problems can quickly spread around the world and trip up the U.S. stock market.
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