Typography

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 prod...

There are thousands of fears, from arachnophobia to globophobia (fear of balloons) to zoophobia (fear of animals). What might the fear of market illiquidity look like? Say that you are petrified that a day will come when markets will be too illiquid for you to convert your wealth into the things you need. There are two ways for you to buy complete peace of mind. The first strategy involves selling everything you own now and buying checking deposits, the sine qua non liquid asset. Get rid of the house, the bonds, the stocks, the car, your couch, and your books. Use some of the proceeds to rent a house and a car, borrow books, and lease furniture. In renting back the stream of consumption benefits that you've just sold, your level of consumption stays constant. Negotiate the rental arrangements so that the lessor—the owner—cannot cancel them, and so that you can walk out of them at a moment's notice. Structuring things this way ensures that rental obligations in no way inhib...

I'm currently updating my History of the Fed chart . As a side project, here's what's happened to the various Federal Reserve credit programs initiated during the crisis. Most of them have rolled off the Fed's balance sheet. Even the most toxic of them - Maiden Lane I and III - seem set to be paid off. Go to scribd to see a higher resolution pdf. Alternatively, my public gallery has a high-res GIF. This chart illustrates one role of a central bank, that of lender of last resort role. A central banking facing a crisis is supposed to lend to everyone on any sort of collateral and buy all sorts of assets. If you read through the fine print of the chart, you'll see that the Fed's new facilities accepted a broad range of assets - from commercial paper to CDOs to RMBS, and opened themselves up to a fairly wide array of counterparties. What is really happening here is that the Fed is providing liquidity insurance. Liquidity insurance is like any other form of insuran...

Inspired by Perry Mehrling and Fischer Black: I think I'd take your future ideal financial model even further (slide 9). The C5 in your model provides what you call liquidity puts. I see no reason why these liquidity puts need be provided by a central bank. In the future, financial products called liquidity options - the option to buy or sell some asset (say Apple stock) at a guaranteed point in the bid-ask spread - would be popular financial products traded on organized exchanges. Just as Apple CDS allow investors to split off Apple credit risk and distribute it across the economy, so would Apple liquidity options split away the liquidity risk of transacting in Apple stock in the secondary market and evenly distribute this risk to those willing and capable of holding it. A private liquidity options market has some advantages over a monopoly last resort system. Liquidity would be competitively priced and no longer supplied in an opaque manner. Central banks would either vacate the...

Nick Rowe had a good comment on the CCPA's recent allegation that Canada's big banks were subsidized by taxpayers. In the comments I pointed out the difficulty of determining whether a subsidy or penalty had been paid to the banks because we lack a way to properly price and therefore compare the provision of liquidity services. In effect, a government program called the Insured Mortgage Purchase Program (IMPP) announced it would buy $125 billion worth of insured NHA-MBS from the banks. It eventually bought $69 billion worth. In an alternative world, the same result is arrived at when NHA-MBS liquidity options are sold by private actors to holders of NHA-MBS. These options allow NHA-MBS holders to sell all MBS back to the option writer at any time at a liquidity-protected price (some favourable point in the bid-ask spread). In a liquidity crisis bid-ask spreads increase, so the value of these options would quickly rise. The CMHC/IMPP provided MBS holders with a liquidity option...

Perry Merhling had an interesting quote from Fischer Black: Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk; and one would bear the risk of default. The last two would not have to put up any capital for the bonds, although they might have to post some sort of collateral In the comments I pointed out that a fourth person can be added to the list - someone who bears the liquidity risk of that corporate bond in the secondary market. This would amount to a liquidity option. Essentially, the bearer of liquidity risk would allow the bond owner to sell that bond at some preset level in the bid-ask spread. For instance, the option could allow the bond owner to immediately sell their entire bond holdings at the upper end of the spread, or at the ask price. Normally, sellers can only sell quickly if they accept a price near the bid price, or lower end of the bid-ask spread. When il...

Nick Rowe brings up the topic. There are plenty of interesting comments there on how this would work. In particular, how would the Icelandic banks secure liquidity if they were to move to a Canadian  dollar standard? It seems to me that local Canadian banks could act as lenders of last resort to the Icelandic banking system. Alternately, if Icelandic banks were willing to submit to Canadian regulation, then perhaps things could proceed one step further and get admittance to the Canadian Payments Association, Canada's central clearing system. As members they would get Bank of Canada lender of last resort assurance.

Commented at Macromania on "On Bagehot's Penalty Rate" .  I think you have captured an inconsistency in the Bagehot principle. If the guiding rule is to lend at a penalty rate, then during a liquidity crisis how can the central bank ever fulfill its duty as lender of last resort? The rate that the market requires will rise but the penalty rate will rise even more, such that the central bank effectively prices itself out of the market. After all, if you can transact with the market at x%, why transact at x+1% with the LOLR? Some liquidity provider that is.  At the same time, I'm sure we can all agree that the job of a LOLR is to provide liquidity, not set market prices.  I think the problem here is that we haven't learnt how to properly understand and measure liquidity, and therefore can't price it and provide adequate liquidity insurance policies. Central banks certainly aren't great at it. Because their tools are so blunt, as an unfortunate by-product of ...