Skip to main content

Liquidity liquidity everywhere but not a drop to drink

One of Gustave Doré's illustrations of The Rime of the Ancient Mariner, plate 4

The minsicule bid ask spreads we see in financial markets today indicate that stocks and bonds have never been more liquid. At the same time, skeptics worry that the odds of a sudden evaporation of this liquidity has never been higher. This Jekyll and Hyde world of ultra liquidity coupled with heightened risk of liquidity famines is one of the core themes running through a great series of posts on market liquidity from Liberty Street, the NY Fed's blog. See here, here, and here.

To protect their portfolios, investors need to be able to look beyond the incredible amounts of potentially superficial liquidity coursing through markets and plan for future illiquidity crisis. For this sort of preparation to be possible, what investors really need is a market in long-dated liquidity-related financial products.

Central banks have historically been the chief providers of liquidity-related financial products, namely liquidity insurance, or the guaranteed use of central bank lending facilities in a crisis. The problem, as Stephen Cecchetti and Kermit Schoenholtz point out, is that we simply don't know if central banks are offering this financial product at the right price and in appropriate quantities. Cecchetti & Schoenholtz say that providing lending facility access: 
without limit and without penalty can lead to enormous moral hazard, causing overreliance on the central bank. If market participants are trained to ignore liquidity risk in good times, they will do little to make markets less fragile or to prepare themselves for unanticipated, but persistent episodes of market illiquidity.
The other problem is that central banks only provide liquidity insurance to banks. What about the rest of us? How can all investors, and not just bankers, benefit from properly priced liquidity insurance products?

---

A central bank is a monopolist without much business sense. It has no idea how to set the proper price for insurance products. Which is why I think a private market in liquidity options, or liquidity insurance, may be an ideal solution.

How might these liquidity options look?

An option to sell at the ask price

In financial markets there is a price at which participants are willing to buy and a price at which they are willing to sell. This is the famous bid-ask spread, or bid-offer spread.

Say the bid, or buying price, for Google shares is $650 and the ask price is $660, the width of the spread being $10.

A seller with time on their hands will join the queue of sellers already at $660 and wait for a buyer to step forward. If the seller is desperate for liquidity, they will sell at $650 to the first buyer in the bid queue, absorbing the $10 loss. When a liquidity crisis hits, this spread may widen out such that a desperate seller will only be able to get out at $640, or $600.

Liquidity risk can be thought of as thusly: We'd all love to rapidly sell at the offer, or ask price, but reality forces us to trek the distance across the spread and sell at the bid. In normal times, who cares; the spread is miniscule. But this trek-to-the-bid gets much costlier in a crisis when spreads widen out.

A liquidity option would be designed to allow investors to do the impossible: sell rapidly at the offer price. Using the Google example from above, an investor who buys a Google liquidity option would be allowed to exercise the option and immediately buy Google from the option seller at the current market offer price, say $660, and not the bid price, say $650. If buyers were to flee and liquidity evaporate such that the level of bids falls to $600, the owner of the option is protected since they can sell Google at the offer price of $660, and not the much lower bid price of $600.

Think about it this way. Whereas a regular put option provides downside price protection by allowing the owner to sell at a fixed price, a liquidity option allows them to sell at a fixed spread. Buying liquidity protection for one Google share would probably be much cheaper than getting downside price protection for that same share.

What should the price of a liquidity option be? Say that the difference between Google's bid and ask is typically $10. An insurance writer who is is required to purchase Google from the option owner at the offer price can typically only offload this risk by turning around and selling Google at a $10 loss. They will therefore require an initial insurance payment, or premium, of at least $10 to compensate.

When a liquidity crisis hits the current bid-ask spread will widen and insurers will ask for higher premiums on newly issued insurance. If current liquidity stays healthy but the odds of future liquidity crisis increase such that future Google bid-ask spreads are expected to be quite wide, then the liquidity insurance writer will require more compensation as well. The value of a liquidity option depends on both current and expected illiquidity. Conversely, if liquidity risks are expected to decline, buyers will ask for lower premiums since they don't expect the insurance to offer much protection over its contract life.

Those investors who have hedged against liquidity risk by buying liquidity options need never fear illiquidity again. If liquidity stays healthy their liquidity options will expire worthless but they'll have no problems exiting their positions. If liquidity deteriorates they can no longer exit their positions directly by selling on the market but can just as easily get liquid by exercising their options.

In addition to Google, a well designed liquidity market would have liquidity options on all major equities, ETFs, and widely traded fixed income products. Full democratization of liquidity insurance would be achieved by having these options trade on public markets. Information about the price of liquidity would become widely available so that investors could "internalize liquidity risk", as Cecchetti & Schoenholtz put it. If they didn't like the risks they found themselves facing, investors could use these products to reorient themselves. Take a family with a mortgage that was too afraid to buy Google because of the potential for an outbreak of illiquidity at the same time that a mortgage payment comes due. The can now own shares and hedge away their liquidity risk by purchasing a liquidity option. Folks like Warren Buffett, a conservative investor with a strong balance sheet capable of withstanding liquidity crisis, would be able to earn extra income by writing liquidity options and collecting premia.

In sum, with a well designed liquidity options market, the risks of illiquidity are distributed to those who want to bear them and away from those who don't. Markets will probably be much less fragile. As for central banks, with the market providing both liquidity insurance and liquidity pricing, central bankers can focus much more on what they should be doing; monetary policy.
Labels:

Comments

Post a Comment

Popular posts from this blog

Shadow banks want in from the cold

Remember when shadow banks regularly outcompeted stodgy banks because they could evade onerous regulatory requirements? Not any more. In negative rate land, regulatory requirements are a blessing for banks. Shadow banks want in, not out. In the old days, central banks imposed a tax on banks by requiring them to maintain reserves that paid zero percent interest. This tax was particularly burdensome during the inflationary 1970s when short term rates rose into the teens. The result was that banks had troubles passing on higher rates to savers, helping to drive the growth of the nascent U.S. money market mutual fund industry. Unlike banks, MMMFs didn't face reserve requirements and could therefore offer higher deposit rates to their customers. To help level the playing field between regulated banks and so-called shadow banks, a number of central banks (including the Bank of Canada) removed the tax by no longer setting a reserve requirement. While the Federal Reserve didn't go as f...
Post a Comment
Read more

The bond-stock conundrum

Here's a conundrum. Many commentators have been trying to puzzle out why stocks have been continually hitting new highs at the same time that bond yields have been hitting new lows. See here , here , here , and here . On the surface, equity markets and bond markets seem to be saying two different things about the future. Stronger equities indicate a bright future while rising bond prices (and falling yields) portend a bleak one. Since these two predictions can't both be right, either the bond market or the stock market is terribly wrong. It's the I'm with stupid theory of the bond and equity bull markets. I hope to show in this post that investor stupidity isn't the only way to explain today's concurrent bull market pattern. Improvements in financial market liquidity and declining expectations surrounding the pace of consumer price inflation can both account for why stocks and equities are moving higher together. More on these two factors later. 1. I'm with...
Post a Comment
Read more

Does QE actually reduce inflation?

There's a counterintuitive meme floating around in the blogosphere that quantitative easing doesn't do what we commonly suppose. Somehow QE reduces inflation or causes deflation, rather than increasing inflation. Among others, here are Nick Rowe , Bob Murphy , David Glasner , Stephen Williamson , David Andolfatto , Frances Coppola , and Bill Woolsey discussing the subject. Over the holidays I've been trying to wrap my head around this idea. Here are my rough thoughts, many of which may have been cribbed from the above sources, though I've lost track from which ones. Let's be clear at the outset. Inflation is a rise in the general price level, deflation is a fall in prices. QE is when a central bank purchases assets at market prices with newly issued reserves. In equilibrium, the expected returns on all goods and assets must be equal. If they aren't equal then people will rebalance towards superior yielding assets until the prices of these assets have risen high...
Post a Comment
Read more