Wednesday, 24 February 2016

Market Lquidity

In the last post I was focused on the behaviours and states of firms with respect to this measure of liquidity.  In this post I will shift focus to the market for securities. 

With the Coasean definition of the firm clearly in mind, it is important to see the relationship between firms and markets.  Firms are economic spaces where various efficiencies make production inside the firm more worthwhile than sourcing the product directly from the market.  But firms need markets for their survival.  They source materials and funding from marketplaces.  They sell their own products on markets.  They are non market entities in a sea of markets.

But markets themselves aren't actors in the sense in which a firm is an actor.  A firm has projects, has responsibilities, obligations, fiduciary, legal, creditor obligations.  Yet markets themselves can be characterised by measures of liquidity too.  Any given market, at various times, can reasonably be characterised as more or less liquid than it was, or in comparison to other markets.  If is often the case that relative market liquidity is stable enough for there to be a more or less natural ranking of markets in terms of their liquidity. 

So, for example, cash markets are considered usually the most liquid.  This is not an economic axiom, it just usually happens to be the case.  Next there are so-called cash-like markets (certificates of deposit, sovereign bonds and so on)  Each market in isolation can experience moves of liquidity on its own terms, through time.  There is, if you will, a variance on the standalone liquidity of the market.  Each market will have its own long term (normal) liquidity level, and its own variance.  As well as the 'in isolation' metric, each of these markets can be compared to each other to rank them in terms of most to least liquid - this rank order whilst not immutable, is often a stable ranking.  The ranking is a ranking of the mean liquidity.  The variances themselves could be ranked too, as could their volatility of volatility.  All three resulting rankings would be interesting and would probably usually correlate well with each other.

It is, of course, the degree to which this stability breaks down which is often the primary focus of a liquidity analysis.

The collective opinion of market participants is what ultimately drives not only the relative liquidities of the various markets  but also the fate of firms during periods of so-called illiquidity,  since it is bond holders and other creditors through capital markets which can determine the demands on a firm with respect to liquidity.  Clearly many markets are, at any given time, more or less similar to each other (Vodafone and Telecom Italia equity markets, for example are more similar than a Shell dividend swap is to a Japanese asset swap).

In the next posting, I look at what it is about certain markets, what attributes they have which drives this opinion of market participants.

Firm Liquidity

Liquidity is a slippery topic.  First of all, there isn't much official financial maths behind it.  Second, it often crops up in discussions differentiating organisations which are insolvent versus those which are merely illiquid.  The argument goes like this: we (the person, the firm, the market, the economy, the geographic region, the world) are in a moment described as solvent-but-illiquid (SBI).  This is a strange state to be in.  The distinction leads Walter Bagehot to suggest that, for central banks, there are certain solvent-but-illiquid moments for banks which need central bank action to provide liquidity at a cost to good banks.  This behaviour is often referred to as being the lender of last resort (LLR).

But just what is this moment?  Let us identify the other two states which a firm might find itself in as solvent-and-liquid (SAL), which one presumes is the healthy state.  Then there is insolvent, period.  It makes no sense to distinguish insolvent and illiquid from insolvent but liquid.  The state of being insolvent clearly dominates both.  This state is then I.

So we find firms mostly living in a world of SAL until the company fails and finds itself in the I state.  The bankruptcy laws of most legal jurisdictions determine the dominance of the I state.

Notice though that even here there are subtleties to the rather simplistic model above.  Corrupt firms may be allowed to survive by cronies in positions of power beyond the point of I.  There's a moral and a legal dimension to this, which is not the subject of the current posting, so let me ignore it for now.  But there's certainly a practical element here.  If by any means, fair or foul, a company can be said to still be able to function for a period while any expected independent accounting audit of its books would reasonably conclude that it is bankrupt, the point remains that firms can be 'technically' insolvent yet remain in business.  That subset of technically insolvent firms may be reasonably classified as additionally either liquid or illiquid.  So perhaps IAL and IBI are both worth considering.

Furthermore, even after a company goes bankrupt, that process itself is a period during which levels of liquidity may vary.  Measuring liquidity may not stop just because a company has been declared bankrupt.  Part of the process of restructuring, indeed, revolves around estimating the new organisation's expected short medium and long term liabilities and the new structure must aim to allow for sufficient liquidity to allow those liabilities to be met.

So in general liquidity is a valid measure across all states of the firm.  There are finally those states of a firm where the firm literally ceases to function as a firm - it simply dies as a meaningful economic entity.  Let us call that state D.  STate D is the state where liquidity no longer matters.

SAL, SBI, IBL, IAI and D are the main categories into which entities can be said to fall for the purposes of liquidity.  Next I will talk in general about liquidity and the market.