The Fuss about Market Liquidity

The recently released PwC “Global Financial Markets Liquidity Study”, sounds a warning.  Financial regulation, while perhaps well-intentioned, has gone too far.  Banks may be safer but markets are more fragile.

At the moment, this fragility is masked by the massive liquidity operations of world central banks.  But it will soon be revealed as, led by the Fed, central banks attempt to exit.  Now, before it is too late, additional regulatory measures under consideration should be halted (Ch. 5).  And existing regulations should be urgently revisited with an eye to achieving better balance between two social goods, financial stability and market liquidity, rather than the current focus on stability at the expense of liquidity (Ch. 3).

The bulk of the report consists of market-by-market empirical documentation of the reduction in market liquidity in past years (Chapter 4, pp. 51-104).  Pretty much all markets have been affected, even sovereign bond markets, but especially markets that were already not so liquid.  “There is clear evidence of a reduction in financial markets liquidity, particularly for less liquid areas of the financial markets, such as small and high-yield bond issues, longer-term FX forwards and interest rate derivatives. However, even relatively more liquid markets are experiencing declining depth, for example US and European sovereign and corporate bonds” (p. 104)

“Bifurcation”, meaning widening difference between vanilla markets now supported by central clearing and everything else, is a repeated watchword, as well as “liquidity fragmentation” across different jurisdictions.  Both are taken to be obvious bads.  But are they?

The central analytical frame of the report is that market liquidity is always and everywhere a good thing, and that more of it is always and everywhere better than less.  “We consider market liquidity to be invariably beneficial” (p. 8, 17).  “We consider market liquidity to be beneficial in both normal times and times of stress. For this study we therefore work on the premise that market liquidity is invariably beneficial” (p. 23).  Accept this premise, and everything else follows.  But why accept the premise?

To be sure, economics quite regularly adopts the simplifying assumption that all markets are fully liquid, so that supply always exactly equals demand and markets always clear.  (On page 17, the report cites the venerable Varian microeconomics text as authority.)  It’s a good assumption if you are concerned about something other than market liquidity.  It is a terrible assumption, and a terrible premise, if you are concerned exactly about market liquidity.

In fact, the idealization of full liquidity in every market is logically impossible in a world where market liquidity is provided by profit-seeking market makers.  In such an ideal world, market-making profit would be zero, so no market-maker would be willing to participate! The idealization thus makes most sense as a world where liquidity is provided for free by government.  It is thus quite inappropriate as a measure of how far current reality falls short of optimum.

The report complains that regulators have addressed each market in isolation, without considering the overall impact of all the regulations added together on markets as a whole.  But the report itself commits exactly the same analytical error.  It thinks about market liquidity as something supplied by individual profit-seeking dealers, along the lines of the famous Ho and Stoll (1981) model (Ch. 2).  But it never asks about the properties of the system comprised of many such profit-seeking dealers competing with another.  They have a dealer model, but they have no money view.

What they call bifurcation, I would simply call hierarchy or tiering, which is a natural and ubiquitous feature of all credit systems.  What they call fragmentation, I would simply call essential hybridity, different local balancing of money interest and public interest.  Maybe there is too much bifurcation and fragmentation, but maybe also there is too little; that’s what we need to discuss.  What we can say for sure is that zero bifurcation and zero fragmentation is impossible.

The financial crisis made clear to everyone that the existing regulatory apparatus was inadequate for the emerging market-based credit system, as well as the larger financial globalization trend.  In the regulatory response that followed, we shifted the matched book dimension of market-making substantially to central clearing counterparties, and the speculative book dimension off of the balance sheets of banks (the Volcker Rule).  This shift  was not an inadvertent mistake, but rather a deliberate attempt to separate the liquidity risk of matched book (which arguably requires and merits public backstop) from the solvency risk of speculative book.

That said, it is clear that we are feeling our way into the future, all of us.  The crisis revealed to everyone that abstraction from liquidity is abstraction from an essential feature of reality.  Markets have already responded by pricing liquidity more explicitly, appreciating that, like any scarce good, we need to make sure it is allocated wisely.  The question is not whether market liquidity is “invariably beneficial” or not, but rather whether the social benefit is greater than the social cost.


6 comments on “The Fuss about Market Liquidity

  1. What strikes me first is what the report means by ‘low liquidity’, in other words, how do they know whatever their measure is, is correct? Following your line of reasoning could I interpret your critique as – there is some sort of sense of insecurity regarding stability in financial markets which has resulted in overcompensating market liquidity (at all times)?

  2. Bruce Krasting on said:

    Interesting timing for this article. There was a crack in the markets last week. A surprise devaluation from China. In the end, not that big a deal, but global markets shuddered for a few days. However, the damage was very big in the high yield market. Spreads in this segment widened out 3% to over 16%.

    I follow this stuff. That was an ‘out sized’ move. Liquidity was definitely a factor.

    Who cares about liquidity in CCC credits? As of today not very many. But that was the same attitude toward junk mortgages in 2007.

    The problem of instability/liquidity in the bottom rung of the credit ladder is that these things typically climb up the ladder. If this type of volatility crept into the investment grade market there would be a sizable blowout. The US debt market is still the lynch pin to the global markets.

    Let’s hope that we never have to calculate the social costs of a liquidity blow-up. The numbers would be huge.

    • MisterPhi on said:

      The liquidity problem, when it arises, is then compounded by risk management (i.e. VaR) factors and risk avoidance by those who have trading-related vested interests (i.e. bonuses and performance related salaries).
      We’ve already seen that happening in euro corps back in 2009, when bid-ask spreads blew up out of proportion and execution levels, where at best dodgy (call it “slippage” if you wish, it was more like a crater).
      The ongoing sell-side narrative in “safe” products does little to help: buy an ETF and you have no exposure and risk to single-name volatility because you’re investing in a number of issuers. But everybody seems to forget how correlations explode between asset classes and securities when things take a turn for the worse; the pricing and market structure underlying those same ETFs are the same trading desks that are conditioned by VaR and profit-maximization (i.e. risk avoidance).
      At the end of the day it seems quite ironic that in a world awash with central bank liquidity, there can be so little available to stabilize markets when it is most needed.

  3. Phil Prince on said:

    Interesting – but the statement, “we shifted the matched book dimension of market-making substantially to central clearing counterparties,” applies only in the risk-dealing channel. In the equally important money-broking channel, matched book dealing still takes place on the increasingly constrained balance sheets of major dealer banks. Without the funding liquidity created by the expansion (and contraction) of those balance sheets, market liquidity will likely be constrained in any sudden move.

  4. Thorvald Grung Moe on said:

    Excellent and timely post; with market liquidity now discussed all over, there is an urgent need for analytical rigour like this. Recenty Brooking conference and YouTube from june CFTC meeting provide much needed industry input on what liquidity really is in the market place, and how important it is to differentiate between markets. Liquidity has been underpriced for long and created a false sense of security (“liquidity illusion”); combined this with AM funds promising daily redemptions is a deadly coctail.

  5. Riaz Tayob on said:

    Perhaps I am out of my league here, but what is the reason for PWC making these kinds of statements and policy positions? I would like to move beyond the “paid shills” for BigFinance, to understand the “logic”/rationale behind their position (and reliance on particular ideas. Could it be that liquidity allows for churn, so profits can be taken from the froth? Why is it that illiquidity in markets is not regarded as a “pricing” adjustment (in normal times or bad times)… after all, if prices drop to a point where there are takers, then that ought to be the equilibrium, or no?