Commenting on Martin Wolf and Liquidity

Martin Wolf writes,

The big problem with such analyses of market liquidity is that things tend to look fine until they do not. One has to focus instead on the tail risks. For this reason, complaints about the impact of bank regulation should be ignored. The difficulty with the complaint is that in the run up to the global financial crisis, few worried about a possible disappearance of market liquidity. But it vanished when most needed, even though none of those onerous regulations then existed. Thus, the absence of regulation exacerbated the liquidity boom and subsequent bust. If relaxed regulatory requirements encourage banks to provide liquidity in good times, only to run away when unable to fund themselves, we end up in the worst of all worlds. Overconfidence in fair-weather liquidity should be discouraged. Investors ought to worry, instead, since the risk that nobody will be on the other side of their trades is a real one.

Agreed, although it bears to remember that regulation is a double-edged sword. The absence of regulation in the past does not prove that it does not partially provide the reason for lower liquidity this time. And alternatively, it is false to derive that regulations would be impotent for preventative and mitigative purposes either.

The trick  is to figure out how to tilt the favour towards the advantages of regulations while lessening the adverse affects. To add, I don’t think overconfidence is an apt description of what investors possess these days.

He continues,

We should contest the conventional wisdom on the benefits of market liquidity propounded by the IMF. The world economy should not be based on confidence in something likely to vanish. It would be better if investors appreciated the risks of a freeze in market liquidity in riskier financial assets.

If investors ‘appreciated’ the risks of possible lower liquidity during normal times or tail events and take those into account, this would drive up the risk premia. This is not necessarily a desirable consequence. In other words, a higher ‘insurance’ or liquidity premium demanded by investors would make the market more costly.

As much of a headache it is to model this liquidity premium, it still shapes the yield curve and the fact that liquidity ‘vanishes’ in Mr Wolf’s word, during tail events makes it even more important that we study it.

But all is not lost, better structuring and a little bit more thought in making the market more efficient and considering the distribution or concentration of ownership would counter this need for assurance and insurance. We’ve learnt the hard way what works and what doesn’t, it is time to put that knowledge into use.

Next paragraph,

Furthermore, markets in which a huge proportion of participants buy not to hold, but in the hope that they can jump off profitable bandwagons in time, are likely to be both unstable and unproductive. The question, at its most basic, here is whether the shibboleth of market liquidity is consistent with the need for markets to have informed and committed investors.

There will always be many different types of market participants. The idea is to not have one group have unfair advantage over another. No way can a market ever be fully filled with sensible, informed and committed investors at all times, or any time for that matter.

Working with what we’ve got, how do we make the markets more attractive to encourage trades and yet avoid catastrophe?

He concludes,

If liquidity is such a fickle friend, should we hanker after it at all? Would it not be better if investors understood that the assets they own might not be liquid in all circumstances and made investment decisions on that assumption? I would suggest that markets characterised more by longer-term commitments, and less by hopes of finding “greater fools” willing to buy at all times, might be better for most of us. This will not be true for all assets — notably government bonds. But it will be true for many private instruments.

Particularly given the current role of mutual funds subject to redemption on demand, policymakers must plan for the next panic. But keeping markets liquid when panic comes risks making the next crisis worse. We have become addicted to market liquidity. But it is too fragile and perverse in its effects on incentives to be viewed as a universal feature of our capital markets.

As I’ve said before, liquidity is a positive social externality. And the momentum of liquidity can move either way, increasing and decreasing, and this movement is affected by factors such as overly onerous regulations, loss of confidence in the price discovery mechanism, unstable market environment, perception of increased risks and so many more.

It is not that participants are ‘hankering’ after liquidity, but what the market participants have been saying is that they’re observing a change in the trading situation and it is not for the better. Whatever that may have caused it, they are worried about where this is progressing to. Perhaps it is a natural result of the economy, but perhaps there are certain things that exacerbate the situation, and this needs looking into.

The solution is not to wait until panic occurs to mitigate by providing liquidity, but in thinking about the structure and contingencies before it happens.

As an aside, liquidity considerations can even affect our risk-free benchmarks. If there is a possibility of added liquidity risk thrown into the mix, then the comparison and valuation of other assets, especially that of riskier assets would prove to be a murkier exercise. In a FT June article,

To measure this JPMorgan’s bond strategy team took the top three bids and offers in “on-the-run” (newly issued) Treasuries in the early morning, when trading is more active. They found that depth deteriorated severely during the financial crisis, and occasionally at times of stress since, but has averaged about $171m for 10-year Treasuries over the past eight years. This year the depth has averaged only $116m.

While US Treasuries remain a cornerstone of the global financial system, as the default risk-free assets of choice, one of their main advantages is liquidity. If that is falling then investors might demand slightly higher yields as compensation.

And as for this sentence, “But it is too fragile and perverse in its effects on incentives to be viewed as a universal feature of our capital markets”, take a step back and think for a moment why an efficient market requires sufficient liquidity.

imf

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