Anyone reading the financial press these days comes across the word ‘liquidity’ alone or in combination, e.g., liquidity gap, liquidity risk, liquidity injection etc more often than the previous favorite expression ‘sub prime’ and its combinations.  As such, liquidity has easily become the most misused economic term of recent months. Liquidity seems to be the cause, the solution, the destination, the journey and the process to address the current financial upheaval.  It is high time that we finance professionals make some sense of very distorted perceptions on the concepts of market liquidity and their proper application to the context of current financial markets.

Liquidity really has two different meanings in the most general sense: one, it is the cash or funds readily available and needed to cover current payments, outgoings or liabilities. We call this financial (timing) liquidity. It is an established and well understood concept and every household understands this otherwise there is no food on the table or no gasoline in the tank. Two, liquidity is the ability or probability to sell a security or an asset at the price offered with a short time.  We call this market liquidity.  Both are very different but equally relevant in the context of current financial markets. These remarks are about the more complex term market liquidity.

Market Liquidity

In its simplest conceptual form, market liquidity is the willingness of a buyer to buy a security or an asset at a specific price offered.  When many willing buyers exist at the offered price, we have a liquid market.  Typically in such liquid markets many transactions take place – we have high turnover.  Conversely, when there are no buyers or no buyers at the price offered, we have illiquid markets.

Unfortunately, life is more complicated because not all securities or asset markets have daily or regular transactions but are still liquid, that is at some infrequent point of time, many willing buyers exist at the price offered. It is therefore very difficult to define one measure of liquidity. The art market is a good example.  Contemporary works of art seem very liquid at the moment as prices are spiraling upwards (ie many willing buyers to pay the offered price or more due to the auction format) but you can only buy such work of art at selected auctions and at specific times. So, markets with infrequent transactions can also be liquid.

We therefore need to further enhance our reasoning by introducing the element of time. One could argue that at some point in time, every asset can find a buyer at the desired price and therefore all markets are by nature liquid.  This is tautological.  We have to introduce a reasonable time frame into the notion of liquidity otherwise we can hardly differentiate between liquid and illiquid markets. Every security and asset class has different time frames in which we can expect a trade.  Equities typically trade in minutes or worst days, bonds trade in days, weeks or months, and certain investment vehicles may trade at quarterly or half yearly intervals.  We therefore cannot postulate a generally valid timeframe applicable to all assets or asset classes but we can say that if within a reasonable or average time frame specific to the asset, a trade can be expected, then we have market liquidity.

To complicate matters further, we have markets with high turnover that cannot be considered liquid.  Let us remember that liquidity requires buyers at the price offered, so if markets have high turnover but prices are dropping rapidly, we have high turnover but at distressed prices.  Technically speaking, there is liquidity because the transaction actually took place (there was a willing buyer at this price) but we have to limit our liquidity reasoning to realistic prices. Otherwise again every market is liquid because at some price every asset can be sold – same tautology as before.

But liquidity is not a supply side concept requiring a willing seller at any price.  There is solid foundation for linking liquidity to the buyer and not to the seller.  A rational buyer buys a security or an asset for only one of three reasons:

Buyers either see value at the price offered or believe that someone else will eventually offer a higher price (eg speculators). In markets with multiple cash options and multiple forward prices or in markets lacking full transparency or in imperfect markets, there is asymmetric information and the rational buyer can arbitrage based on superior information or analytics.  However, because the rational buyer is competing with other rational buyers, prices are contestable.  This is not always the case with sellers, eg distressed sellers, short term need sellers, rational losers etc.  There are many circumstances for a seller to trade at less than fair value price.  Because the logic for a seller may not be widely applicable or contestable, we require buyers to define the market price and market liquidity.

Delineating price as the last determinant of market liquidity is complicated.  Most definitions refer to some fair value concept but in the end, fair value is equally elusive even under IFRS.  Just consider volatile markets or when fundamental values change rapidly or when market information is distorted. Today’s markets are a good example.  If one major bank share price dropped by 80% over the last twelve months then this may not mean that its fundamental value has equally dropped by this amount because there may be panic in the market or distorted information leading to serious undervaluation of this share.  On the other hand, if buyers are only willing to buy at distressed values (undervaluation), then we can hardly speak of a liquid market. Crashing markets are not liquid markets despite its turnover.

Therefore, we must equate fair value or reasonable price with or around the last trade made.  This stands to reason because if the last trade was not made by someone insane, then this last price is the fair market value at this point in time.

We now have a complete definition of market liquidity. Market liquidity offers participants a very high probability of finding a willing buyer at or around the last price achieved and within the security or asset typical time frame.

In fact, market liquidity so defined is different to price risk. Strictly defined, price risk is the unexpected change in price or returns (unexpected after applying experience, stress tests and simulations) – not the reasonably expected potential change in price because say fundamentals have changed. Price risk does not include the requirement of a buyer (is a hypothetical price change) as mandated by market liquidity.  Last price offered (or around this price) and willing buyer combined result in market liquidity.

A concept of liquidity risk in literature seeks to combine the two: it is defined as the gap between the fundamental value of the security and the actual price at which the trade is executed.  This is somewhat confusing because it introduces a new generic concept of fundamental value. To the market the last price paid (or near enough) is market (fundamental) value and not some artificial value assigned to the security or asset.  If the market revalues a security or an asset for good or bad reasons then this is the new market value and the (perceived) gap to some (notional) value is market judgment of the day.  Liquidity risk as a gap is more a forced seller price risk or quantification of distress cost.

In the financial press today all of these terms and concepts are liberally splashed into the text and used inter changeably without much consideration of their meaning. 

Today’s Financial Markets and Market Liquidity

Until the start of the sub prime crisis in August last year, prices for a number of structured, leveraged and engineered securities, particularly those that had somewhere down the line mortgages or property as ultimate asset, were liquid (that is there were willing buyers) and moved at or around the last achieved price.  We had a liquid market. In August last year, market perceptions of the value embedded in these securities changed abruptly (the underlying reasons are not relevant here) and suddenly willing buyers were no longer available at or around the last price, in some cases at almost any price. We were faced with an illiquid market or market illiquidity as a consequence and not the cause.

In our defined terms, this meant financial institutions no longer had a high probability of transacting certain securities at around the last price. Both an event driven and unexpected price risk of sizeable proportions and an unexpected volume risk by the near complete absence of willing buyers materialized within a very short period of time.  Both conspired to creating the worst financial crisis in mankind initially called the sub prime crisis more recently termed liquidity crisis. This is only partially correct..

What really happened was (and ongoing) a fundamental shift in value perceptions, possibly panic and distortions, and therefore a gargantuan downturn in prices at which the securities or assets find a willing buyer.  If we assume for the moment that the change in value perception is grounded in reality, that is these complex mortgage backed securities and other stocks effectively have less intrinsic value because say the underlying mortgage assets are declining in value and/or the debtors repayment ability is impaired due to an economic downturn, then we simply have a market correction and a commensurate adjustment in fair market values or last achieved prices.  This does not amount to a market liquidity crisis but (simply) to a severe, abrupt market correction. 

If we assume on the other hand that these complex securities and other stocks have retained their fair value, then we would have a market liquidity crisis because of the absence of willing buyers at fair value. If then prices do not normalize rapidly, arbitrage (dis-aggregation, repackaging) between the security and the underlying assets would become rampant. The market would correct until values are properly reflected again.  So goes market theory and it works well in practice.  Given the size of bets in the market and the remuneration policies of participants, exploitation of even smaller arbitrage opportunities is heavily rewarded. Selected arbitrage is taking place today. Most of the sub prime and related securities however simply do not find a buyer at around any previous price.

We can safely postulate that we are faced with a severe market correction based on real but probably overcompensated change in fundamental value perceptions. What this means for the accountability and responsibility of players is quite a different question but it has to be pointed out that such a value (price) risk should not have taken professional players by surprise. In fact, some of the best players started covering or unwinding their sub prime exposure since summer 2006.

More interesting is however, recent government reaction.  They claim to be injecting liquidity into the market.  This is of course true in the sloppiest sense of the word where any cash is liquidity (financial liquidity) but in reality they are substituting willing buyers at inflated or arbitrary prices.  Buying assets in that manner must be correctly called investing. Rational loser investing does not add technically to market liquidity because it is not market behavior (else others would do the same). No (few) rational buyers would act in the same way. Prices paid are not contestable and not buyer fair valuation. Markets are impaired.  Market self regulation is thrown out.  Responsibility or accountability for the original security or asset becomes elusive.  Wealth is re-distributed without merit. Artificial profit opportunities are created. Essentially a dysfunctional market is formed with government guarantee. Market intervention.

In fairness, governments make this investment as a rational loser to protect financial system stability or to save participants or whatever noble (political) reasoning may lie behind such action. However, market perception may not improve or values may not correct because of one irrational buyer on the move unless (nearly) all securities are bought. Therein lies one major fallacy of the arguments governments presented.

Moreover, if government is making an investment, the corollary is that the investor government must require a return or reward for taking the risk. Here is where the logic is flawed again.  One, governments are generally very poor investors because they have ulterior motives and captive revenues (resources, taxes etc) – little accountability. Two, there is insufficient emphasis on the return for taking these risks. Without a return potential, this is exposing public funds and the benefits arise in the balance sheets of players and ultimately in the share price and bonuses of executives (Wall Street). Better were to help the troubled individuals recovering from economic decline or suffering from exuberant consumption (Main Street) and leaving market players to deal with their own mess. If governments were to inject capital or some other form of participatory funds, then at least the investment logic stands up and the market is left to work out fair value.

Compare government intervention with the investment say Warren Buffet made in Goldman Sachs or ADIA made in Citigroup.  It is quite obvious that Buffet or ADIA as investors made rational and calculated deals where risks and rewards are balanced from their perspective.

This is the difference between professional investors – they do add market liquidity by being a willing buyer at fair value - and politicians believing they are propping up market liquidity – they distort markets and make poor investments. You could say it all boils down to understanding the difference between market liquidity and distressed investment – a difference that may well have escaped a majority of various legislature members.

We can explain the difference in a very simple way: say that over the last years you have been buying many useless consumer goods and now need to raise some money or empty your storage.  You hold a garage sale and price goods at fair value, say cost minus depreciation minus a discount for motivation. At the sale there are no buyers even if you further discount your prices. Now it would be really good for your self esteem if you could call this a market liquidity crisis when simply put no one wants your junk. You now go to your parents for money.  Instead of getting a loan, you sell them the junk at some inexplicable price.  You now claim that markets are liquid again and are working at their best.  What a world.  Sounds pretty close to what is happening these very days.

Let us finance professionals keep the discussion about market liquidity clear and focused and the reasoning about distressed investments separate – they do not have the same logic or characteristics.

Addendum

There is a major (financial) liquidity aspect in this crisis. This true financial liquidity issue arises from the withdrawal of deposits or inter bank funding or other financial liquidity and has left many players without the means to cover their assets and outgoings.  This is mainly addressed trough emergency re-financing windows in various forms and deposit guarantees by central banks.  The appraisal of the adequacy of these interventions is left to another issue of these comments. 
 
Sources:
H G Fong, Innovations in Investment Management, Bloomberg LP, New York 2008
M Mainelli, Liquidity, Finance in Motion or Evaporation, Gresham College lectures, 2008