Since 2009, S&P 500 trading volumes have seen steady, year-over-year declines putting us back to where we were in 2005. This should be deeply concerning for informed investors. Trading volume provides liquidity, or depth. When volume is high, then there is a large pool of buyers and sellers and block trades are readily absorbed into the market. Low volume, however, means that the market lacks depth. There are fewer buyers for every seller and fewer sellers for every buyer.
This matters. Why? Because a stock market without volume is like a crowded football stadium with a single exit. If there is a crisis or a sudden rush to the exits, who is going to buy when everyone is selling? Normal stock market corrections can be swift, yet orderly. The "orderliness" comes from market depth. The low volume phenomenon we're seeing shouldn't be seen as a potential cause of a market decline, but rather the potential cause of a disorderly market decline.
An extreme example of a disorderly decline is, of course, the flash crash from May 2010 where the Dow plunged 1,000 points (9%) in an instant, only to fully recover minutes later. According to a report by the SEC and CFTC, the market was so fragmented and fragile that a single large trade could send stocks into a sudden spiral. It then detailed how a large mutual fund firm selling an unusually large number of E-Mini S&P 500 contracts first exhausted available buyers, and then how high-frequency traders (HFT) started aggressively selling, accelerating the effect of the mutual fund's selling and contributing to the sharp price declines that day.
It's no wonder, then, why the Federal Reserve is considering placing redemption gates on certain investments which would prevent security holders from selling when they wanted to. The Fed sees the lack of liquidity in the markets and they fear a sudden rush to the exits. This potential policy has been heavily criticized (and rightly so in my opinion) by a number of analysts, such as here and here. If, as an investor, you know that you may not be able to access your money if you invest in certain assets, would you still invest? Of course not. So basically the Fed is stuck between a rock and hard place. If they impose redemption gates, then many investors will start yanking money out in anticipation of those gates. If the Fed doesn't impose the gates, then they run the risk of a disorderly market crash.
Remember, the first ones out the door are the ones that survive.