## Saturday, 5 November 2011

### Liquidity

I'm trying to get it clear in my head just what that slippery financial term liquidity really means.  I've heard it referred to as a synonym for money, I've heard it attributed to classes of security (government bonds being more liquid than convertibles, say), I've even heard it attributed to people themselves.  What is it really?

To my mind, it is best understood as a property of a specific market.  It is an estimate of how satisfactory  some hypothetical future experience you (or any other putative participant in that specific market) might have with respect to price in-elasticity of order size and with respect to minimal price variance.  Let me take that all bit by bit.

First of all, it is an estimate.  By this I mean not only that individuals can have their own opinion on the liquidity of any specific market, but that there can be a degree of inter-subjective agreement too.  We can as a community reach a kind of consensus on the liquidity of a market.  This is based on experience - namely based on how that specific market, or markets like it, have behaved in the past.  In the recent past especially, but also over longer periods of time.  It is an estimate however which is aimed at the future.  Sure, you measure the past and from that it leads you to your conviction about the future.  But nevertheless, when you come to a specific market, you are interested in its liquidity going forwards.  I could invent some fable about a possible world where a specific market has a clear and measurable history of illiquidity, yet be content that some profound, uncontroversially effective change occurred in the world which leads me to estimate it to be likely to be liquid going forward.  These forward looking estimates which you or the market community might have are clearly time-bound - the further out in time, the less certainty we might have for this belief in the liquidity of a specific market.  I wouldn't really need to invent some fable whereby some profound structural real world chance occurred which made a specific market become almost instantaneously less liquid - you just need to see what happens during periods of financial crisis to see this scenario playing out.  What all this means is that it is an estimate which is usually well-founded - based on many experiences in the past - but it can nevertheless break down (or, less often, break to the upside).  Now, whether you want to say that a community was wrong in their previous estimation (or you yourself were wrong) versus saying that the community reserves the right collectively to change its mind in a dramatically short period is probably a question for the philosophy of economics, not for this post.  Suffice it to say that an individual opinion about some future interaction with an individual market can exhibit quite some volatility dynamics.  Perhaps that opinion stays stable in that person's head for years, across multiple business cycles - with virtually no volatility in their estimate of the liquidity of that market.  That same opinion could dramatically shift, perhaps permanently, perhaps temporarily.  This behaviour may or may not be rational economically - that's a whole different argument also.

Ok.  So now we have a forward looking opinion in one person's head about one specific market.  That judgement can at times exhibit remarkably stability or remarkable instability, and we can put this down to rational expectations or less rational psychological causes.  Remaining neutral on that debate for now, I could say that the stability of this opinion over any time window could range from calm to dramatically different, and all shades in between.  When an observable time series behaves like this we say it has high volatility of volatility (high vol. of vol.).  This simply captures the idea that it can exhibit little or no movement for periods, then exhibits a lot of movement in other periods.  So we have a forward looking, high vol. of vol. opinion in one person's head about one specific market.  What next?

When an individual comes to a market to transact, they have a transaction size (or a range of transaction sizes) they'd like to execute.  In general they might also be looking to sell into that market or buy from that market.  And doubtless there are many elements of that market's structure which the participant would do well to pay attention to - its permanence, it legality, the level of trustworthiness of the co-participants, the homogeneity of quality of the units for sale or purchase at that market, any institution of redress to deal with dispute, convenience of location, and so on.  They're all important, but for now I'm focusing on just two properties of that market - the ability of participants to see a price and know that it'll be the same price even if they decide to buy (or sell) a thousand more.  There are, of course, limits to this price in-elasticity - often that market will quote you a buy price and a sell price, each with a maximum lot size.  That price is good for any quantity up to that maximum lot size.  Leaving aside specifics of individual orders, nevertheless, a market participant  might need to transact in size, over multiple lots, and would like to know that they'll still get to transact at the current market price (or thereabouts - nothing is too guaranteed even in theoretical markets ) even if he decided to buy 10 or 10,000 units.  Turning up at a market with 10,000 units only to find the market can only give you a price on 100 of them can be costly economically, so knowing that this market allows you this freedom is a valuable attribute of that market.

Next up is minimally variant price action.  This is a huge subject and I'll do a lot of simplifying here.  Imagine a market with no price variation.  The price is always nominally $p$ no matter what.  That price action is minimal.  Imagine a market with extraordinarily variable price action.  Clearly each market participant will approach those two markets (and all shades in between) with a different expectation, a different feeling of confidence or dread.  If I know with certainty that would get $p$ for selling a unit into a market and expect $p$ back again tomorrow - then I could use that market a bit like a safe deposit box. If I could likewise drop off 1,000,000 units at $p$ and certainly get it back tomorrow for $1000000p$ then clearly this market has uses.  If I had much less certainty about what I'd get back tomorrow - maybe $p$, maybe $0.9p$, maybe $0.00001p$, maybe $1000000p$ - then I would be wise to treat that market differently to the first one.  So far I haven't talked about money or inflation, but you can imagine quite easily how even the first market, in a hyper-inflationary environment, could appear in real terms to resemble the high variance market.  Inflation is not the focus of this post, so I'll only mention it in passing and also mention that, if inflation was growing steadily, or if we were deflating steadily - by which I mean predictably - then we could as market participants work around these known changes and still find some use in markets.  The worst situation is a highly uncertain inflationary/deflationary environment. So when I talk about minimally variant price action, I really mean unpredictable price action.  Forget inflation, if there is a rule which tells me with certainty how much I'll get for a unit tomorrow if I sell it in to that market today, then that's still minimally variant.  Clearly the least variance is when the nominal price stays the same as yesterday - that way you don't need to apply that extra step and run a simple calculation to see what the price should be tomorrow.

Minimal values for these two properties - the degree of price sensitivity to order size and the degree of unpredictable price action - are seen as positive elements of that market.  This is liquidity.

Now, there are so many markets out there.  Some are quite similar to each other.  Others strikingly different.  And our level of precision may vary with interest and purpose too.  This leads us often to be happy to lump together two or more specific markets and make pronouncements about their average liquidity.  To be specific, we individually (and collectively) might have an opinion on the liquidity of IBM's publicly traded equity, on the liquidity of Google's publicly traded equity, but we might also have aggregated opinions on the liquidity of U.S. technology equity issues, or U.S. equities, or equities in general.  Likewise we may have opinions on this month's on the run U.S. T-bill  and slightly different opinions on any other off the run U.S. T-bills, or we might have a singular opinion on U.S. T-bill liquidity in general, or in U.S. Treasury bond liquidity in general, or in G-20 sovereign bond issue liquidity, or sovereign bond issue liquidity.  Hence we can come (individually or collectively) to opinions about the liquidity of whole asset classes.  We could track how that opinion varies through time.  We could analyse the factors which cause those differences.  We could think through the implications of the stability of these inter-asset class liquidities.

When used of a person  or company - what this means is simply that the collection of assets and liabilities which that person or company owns (or a subset thereof depending on the focus of the conversation) belong to asset classes (or individual markets) with certain liquidity attributions.

In any given economic region, money is often considered most liquid, next bank cards and debit cards, then cheques, certificates of deposit, time deposits, Eurodollar futures, short duration highly trustworthy government bonds, longer duration trustworthy government bonds, corporate bonds, equities, and onwards down to highly illiquid assets, including distressed assets, housing stock and so on.  Some assets could experience periods where it is literally impossible to transact in them - their market has seized up completely.

I've said nothing about what causes a liquid market - just how to spot it. But to speak of causation for a moment, I'd say that the stability of price action will have a tendency to make a market to become bigger, which in turn would allow a certain in-elasticity on lot size; so in a sense the core definition of liquidity is in-elasticity of lot size - that's what we see - but this is usually caused by the sheer size of the market, which in turn is caused by the appealing usefulness of low variance on price surprises in that market.  In theory, you could perhaps invent a bizarre story about a world which has the key liquidity element - in-elasticity to lot size - without the other causes, but scale through widely-perceived usefulness is how most markets come to be liquid.  A market which doesn't shock its participants too much is a good candidate for liquidity.  And liquid markets will play some role in the investment perspectives of participants too - but going into that subject of liquidity, investment and money would move me too close to Book 4 of Keynes's General theory for now.

Finally, some people think what I've just described is not liquidity at all, but market fluidity or depth.  They claim liquidity is the property of an asset which allows it rapidly to be transferred from one use to another.  Certainly I would agree with the rapidity of the transaction, which it my mind is a property of the general level of confidence market participants have in particular markets.  Perhaps these two are permutations of the same phenomena - the confidence which must exist in that asset which would allow economic agents to use it so frequently for exchanges, in so many different circumstances is the logical consequence of economic agents coming to realise that it is a better way to run an economy to agree on just one asset - what we call  money - to be the reference asset in many economic transactions.  And that confidence is surely based on the two properties I mentioned earlier.  Money typically is backed by a central authority with an affiliated mandate for price stability or by a real asset, such as gold.  Neither are perfect with regard achieving that stability - consider periods of hyper inflation with fiat currencies, or with moments of discovery of new sources of gold (the Spanish-American experience and the nineteenth century gold rush experience).  To say that liquidity is a property of that asset which we use most frequently in most of our economic transactions is merely to ask the first, and not the most important question about it.