Wednesday, 2 March 2016

Liquidity in context - I

In this posting I'd like to talk about a couple of liquidity related phrases and their meaning.  

First of all the word 'liquidity' itself.  Someone at some point in history decided that describing the degree to which an entity is able to meet its obligations through access to cash when required required a metaphor of a liquid.  If flows everywhere, which I think must be the point originally.  It is from this starting point that you get a liquidation activity, which is when non-liquid assets get disposed of (sold) for cash.  The word liquidation now also carries a strong separate sense, meaning to have its structure (solidity) destroyed (melted).  I think this is secondary.  From bankruptcy terminology, the word has entered common parlance to mean to end or terminate something or someone.

Liquidity risk.
This term, in contradistinction to market risk, credit risk, macro-economic risk (pan-market risk), etc., is an umbrella term describing the measurement and management of the risk that an entity (typically a firm) cannot meet one or more obligations (financial obligations).  As such it is a species of financial risk,  as opposed to non-financial risk.  Cash is a financial asset after all, so no surprise there.

Funding liquidity.
Organisations fund their operations through equity investment in the firm, financial markets debt, bank loans, and various forms of credit or leverage agreement.  Each potential provider of this funding is making an ongoing endless decision about the firm with respect to how worried they are about getting their investment back.  It is this ongoing endless decision which is one of the causes of funding liquidity risk.  Take, for example, a modern hedge fund.  It may have received cash from equity investors in the firm.  This cash received is used to fund projects within the firm.  The resulting equity represents a liability to the hedge fund.  It owes the equity investors.  How much they owe is a function of how the world values that equity component.  Is it work only as much as the original capital investment (i.e. the book cost, in accounting terms) or has the firm managed to grow its enterprise value and hence does the world now value the equity stake higher?  How ongoing is the re-appraisal of the value of the firm's equity?  This can vary a lot.  Publicly listed companies have active secondary markets and hence the current value of the equity is continuously evaluated.  Private firms (as a majority of hedge funds are) get their equity marked much less frequently.  Also, in one sense the final owner of the equity is irrelevant for these purposes.  Whereas equity owners may (and do) decide whether to sell their stake on the secondary market or privately all the time, the principal agents of the firm still regard this liability as ever-present.  In the general case, normal transactions in the secondary market may provide liquidity to the owners of the equity but the company itself has long since used the original capital for various purposes.  In abstract, the  equity owner owns this asset forever (even though their identity changes from secondary market trade to secondary market trade).

Next come bank loans.  Again, cash came in to the fund and a series of obligations got created.  These obligations are utterly different to the firm's obligation to the equity owner.  The loan obligation includes a lot more certainty and specificity - interest payments need to be made on certain dates, the loan has a maturity which is well understood.    Firms use loans on an ongoing basis, so there's always a chance that the loan providers worsen the terms of the loan or fail to consider rolling the loan.  This is a potential cause of funding liquidity risk.  Similarly for all forms of capital market bond - the lender is a collection of market participants, but otherwise the structure and risks are the same.  Next a hedge fund might get leverage from prime brokers.  This amounts to a greater or lesser spending capacity for the hedge fund, at a fee for the prime broker.  Finally the hedge fund itself has a number of investors in the fund vehicle itself.  These investors can be much more flighty and might decide on an ongoing basis to either keep their money in that fund, or redeem their investment, subject to an often complex set of company-imposed withdrawn constraints often called 'gates'.

Funding liquidity risk can be instigated by the firm's loan creditors, the fixed income market in its aggregate willingness to lend the firm new money on an ongoing basis, its investors and even by secondary effects of its equity holders, insofar as selling pressure on the firm's equity may feed back negatively into direct funding sources.  Funding liquidity risk is ultimately caused by one of two drivers - first, the set of funders collectively decide that the firm is less worthy of funding and second the set of funders either individually or collectively themselves become stressed and are caused to reduce the level of their funding to that (and potentially other) firms.

So much for the causes, the mechanism is also two parted.  Firms have ongoing funding requirements.  The degree to which this is lumpy or smooth is a whole world in itself.  But if a firm experiences a funding liquidity episode, then the funders singly or collectively might change or exercise clauses in the current set of in play funding transactions to make the level of funding reduce, or secondly they might worsen terms of new funding transactions with the firm and in the limit completely refuse to offer any additional new funding.  Loans, bonds and converts offer a degree of stability in their prospectuses which allows for funding stability.  Prime brokers can much more rapidly change the terms of their implicit funding pretty much overnight, and hence are a potential cause of much more immediate and unpredictable funding liquidity risk for a hedge fund.  Hedge fund don't often have loans or bonds though, so their primary funding liquidity risk vectors are investor and prime broker flightiness.  So when it comes to estimating the nature of the funding obligation (how much needs to be liquidated and by when or at what cost) then modelling investor gates and the volatility of PB leverage will need to be examined to establish the magnitudes of liquidity risks in various scenarios.