Market Liquidity Risk

Implications for Asset Pricing, Risk Management, and Financial Regulation

Andria van der Merwe

• Publisher: Palgrave Macmillan
• Year: 2016
• ISBN:
  9781137389237
• Topic: Business
• Subtopic: Accounting
• Index: Business

Andria van der Merwe provides a thorough guide to the critical tools needed to navigate liquidity markets and value security pricing in the presence of market frictions and information asymmetries. This is essential reading for anyone with a current or future interest in liquidity models, market structures, and trading mechanisms.

1

Musings on Liquidity

Liquidity is important and necessary. Liquidity is an assumed characteristic of a well-functioning market, but we only pay attention to it when it is absent—like the proverbial umbrella that is missing when it rains.¹ What is market liquidity? Can we measure market liquidity? Can we manage market liquidity?

This question seems trivial (or even uninteresting) to the average person who equates liquidity with money in his or her pocket. An economist often associates liquidity with the availability of money or more specifically with the actions of the central bank, succinctly defined by the former chairman of the Federal Reserve, Ben Bernanke, in a 2008 speech on liquidity provision by the central bank: “Consistent with its role as the nation’s central bank, the Federal Reserve has responded not only with an easing of monetary policy but also with a number of steps aimed at reducing funding pressures for depository institutions and primary securities dealers and at improving overall market liquidity and market functioning.”² Traders on the other hand equate liquidity with their ability to buy and sell securities in financial markets.

However, none of these broadly defined, superficial understandings of market liquidity were sufficient to prevent the devastating and costly effects of illiquid capital markets we experienced during the 2007–2008 global financial crisis. Subsequent events force us to develop a deeper understanding of market liquidity and beg the question whether the market liquidity paradigm has shifted. Consider, for example, some ad hoc observations on liquidity that were made since the global financial crisis. Regarding the “flash crash” of May 6, 2010, the Economist reported, “This ‘hot potato’ trading generated lots of volume but little net buying. Traditional buyers were unable or unwilling to step in, and the depth of the buying market for e-minis and S&P 500-tracking exchange-traded funds fell to a mere 1% of its level that morning.”³

Mark Carney, the governor of the Bank of England, observed that in 2014, “The time to liquidate a given position is now seven times as long as in 2008, reflecting much smaller trade sizes in fixed income markets.”⁴ Carney also commented on the bizarre price swings in the US government bond market on October 15, 2014: “Fundamentally, liquidity has become more scarce in secondary fixed income markets.” These comments were made in 2014, almost six years after the financial crisis!

This chapter provides a historical perspective on what shapes our thinking about liquidity and highlights the premises of the neoclassical financial edifice we need to redefine to accommodate a new market liquidity paradigm.

Historical perspective on trading, liquidity, and financial markets

The role of money and coins in antiquity

What constitutes liquidity has evolved and mutated over time. A common theme throughout is that higher liquidity goes hand in hand with improved quality of information about the value of goods exchanged. Barter, the earliest form of exchange, was slow and uncertain partly because it provided no pricing transparency—if I trade a sword for a goat today, I may have to trade ten pigeons for the goat tomorrow and two swords for the ten pigeons next week. The value of bartered goods was purely driven by whether the seller was offering what the buyer needed. The notion of price or value was not well defined in bartered goods, and the process of exchange was slow.

Around 2000 BCE, silver and gold coins started to replace barter, giving birth to the notion that liquidity is associated with money (or money supply). Trade for coins offered a common calibration, since the swordmaker who accepted five drachmas⁵ last month would probably accept about the same amount again this month. Around the late seventh century BCE, the Lydians created metal coins embossed with royal symbols that guaranteed the weight and purity of the coin. Standardization made coins more useful for daily commercial transactions, which led to coins being widely accepted mediums of exchange. Everyone valued the coins equally; they could readily pay any cost. While barter was slow and costly due to the process involved in examining the attributes of goods typically used in barter exchanges, coins significantly lowered the information cost of transacting by their uniformity, which was the issuer’s guarantee of purity.

Over time, coins became emblems of great civic pride. The creation of coins and the management of their availability by ancient governments was one catalyst for the development of lively, centralized markets, such as the ancient agora, near the Athenian Acropolis, where people could meet.⁶ The ample supply of money lubricated trade and markets throughout the ancient world. For example, in the early years of the principate,⁷ the total Roman coinage per capita came to approximately 80 percent of the current US money supply.⁸

Ancient ports were awash with coins minted in different places. The first bankers were moneychangers—they worked behind tables—tapeza in Greek, and banc in medieval Italian.⁹ Bankers also connected businessmen who needed funds to investors with excess funds. Since few Athenians could fully finance a trading voyage or the construction of a ship, bankers flourished and fulfilled the role of the first financial intermediaries who brokered transactions between several parties. Bankers knew who had the money and who needed it, and they were excellent managers of risk because of their intimacy with the market. Land was a typical form of collateral for a loan. William Shakespeare’s character Shylock in The Merchant of Venice exemplified the debauchery of early bankers whose collateral demand was no less than a pound of human flesh.

Migration away from money to financial market-based substitutes for money

Once metal-based money was introduced, and later in the era of the gold standard, liquidity was associated primarily with money. The fact that money is the most liquid asset and, that the cost of money to pay for things is minimal (often zero) is conceptually attractive. But equating liquidity only with money is too narrow. In 1936, the British Depression-era economist and father of Keynesian economics John Maynard Keynes argued that investors will move from money to assets that are risky and less liquid only if they can expect to earn a reward from them, thereby extending the notion of liquidity away from money to the quality of asset. The market and financial economists after the 1929 stock market crash, consumed by rebuilding the economy, were not ready for liquidity to be managed as a separate risk. Incidentally, the main application of Keynes’s liquidity preference was monetary policy.¹⁰

In 1971, US president Richard Nixon suspended the dollar’s convertibility into gold to avert the mounting crisis of a large trade deficit and a costly war in Vietnam, ending the Bretton Woods system of fixed exchange rates. Floating currencies meant that capital could flow freely between countries, and it created the Milton Friedman world of free market economics. Liquidity was still thought of as money, but with the growth in Wall Street and global markets, at least in concept, liquidity gravitated toward financial markets.

Similar to earlier periods in which coins replaced barter and land was used as collateral for loans, innovation and financial development pushed back the liquidity frontier. The Peruvian economist Hernando De Soto, who revolutionized our understanding of transforming poverty into wealth, argued more generally that the transformation of “dead capital” into “live capital” is a key step in the development process.¹¹

Money is desirable because it acts as “stores of value.”¹² In other words, money serves as an effective cushion against pressing needs during periods of potential future liquidity shortages, thereby mitigating the costs of dealing with uncertainty. Sir John Richard Hicks, one of the most influential economists of the twentieth century and winner of the 1972 Nobel Memorial Prize in Economic Sciences, argued that other assets also have the capacity to act as stores of value.¹³ Hicks suggested that liquidity preference, in the narrow sense of the demand for money, could be created in financial markets. This is exactly what the subsequent processes of financial development throughout the post–Bretton Woods period did—they created substitutes for money. Bank-based systems have naturally produced such substitutes by offering deposit contracts and credit lines, which provide an option to withdraw when liquidity is needed. Competition in the financial sector has spurred the growth of nonbank institutions that offer new products adapted to the liquidity preference of investors. An example of such innovation is the development of index funds during the 1970s. The first index fund available to individual investors, First Investment Trust, was sponsored by The Vanguard Group in 1976.¹⁴ Today, thousands of such funds are available to investors in the form of no-load index mutual funds and exchange-traded funds (ETFs).

The modern form of mortgages¹⁵ is another example of financial innovation that allows consumers to create stores of value, in the form of equity in their homes, when they borrow instead of finance their homes. Their commitment to reimburse interest and principal on their mortgages represents a claim on their future income. This claim can be securitized and transformed into a store of value through the institution of mortgage-backed securities (MBS). The real estate mortgages of US households have grown from 15 percent of their net wealth in 1949 to 41 percent in 2001 due to various factors, such as financial innovation, increased risk taking through high loan-to-value ratios, teaser rates and lack of refinancing penalties, and changes in legislation favoring homeownership.

The process of securitization is another example of how innovation creates a new market-based substitute for money. Securitization enables economic agents to obtain cash more readily against an array of future expected cash flows: from basic assets (loans, securities, and receivables) to other securitized products, such as subprime residential mortgage-backed securities, collateralized debt obligations (CDOs), or asset-backed commercial paper (ABCP). These developments provided market participants with more flexibility to allocate cash flows and manage risk associated with uncertainty, but they should have raised questions about the robustness of the market-based liquidity regime, as we will discuss in more detail in chapter 2.

The relevance of financial institutions and market structures

In a world of ideal, frictionless markets, every commodity would be readily available such that the aggregate supply equals the aggregate demand. The general equilibrium economy suggested by American economist Kenneth Arrow and French economist Gerard Debreu formalized the conditions needed for the aggregate supply to equal the aggregate demand. The so-called Arrow-Debreu model is central to the theory of general equilibrium that paved the way for the development of much of classical asset pricing theory.¹⁶ In this economy, savers can hold assets, such as equity, bonds, or demand deposits, which they can sell quickly and easily if they seek access to their savings. Firms also have permanent access to the capital markets to satisfy funding needs. The arguments supporting the general equilibrium economy do not provide any insight into the important roles of financial institutions, intermediaries, and banks in the provision of market liquidity.

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Table of contents

• Cover
• Title
• 1  Musings on Liquidity
• 2  Financial Crises and Liquidity Traffic Jams
• 3  Market Structures and Institutional Arrangements of Trading
• 4  Asset Pricing and Market Liquidity
• 5  Stories of Liquidity and Credit
• 6  Financial Regulation and Liquidity Risk Management
• Notes
• Index