Liquidity in context III

Yesterday I talked about bottom up asset liquidity.  Today I shall continue reviewing the various forms of words which appear in discussions of liquidity.

Liquidity mismatch.

Think of a firm's need for cash as a demand curve.  And its ability to get its hands on cash as a supply curve.  A liquidity mismatch occurs when this set of curves are out of sync.

I shall give two made up examples - an industrial goods manufacturer and a multi-strategy hedge fund.  First the industrial goods company.

The company already has a number of loans, bonds, convertibles outstanding with a number of market participants.  It also has operating cash and holds a number of near-cash securities.  On top of all of this, it has a set of assets and new projects and ongoing projects.  These ongoing projects deliver cash flows into the organisation.  The expected magnitude and timing of these cash-flows is an ongoing estimation problem for the CFO.  It is also a function of the economy generally, of sales, of a broad range of conditions, in other words.

Meanwhile its financial liabilities (those loans and bonds) have a mostly very clear timeline of coupon payments and repayment dates.  It is, of course, part of the CFO's job to manage all of this, but they are operating in an uncertain world.  Projects may bleed, they may fail catastrophically.  Macro-economic disaster might befall the economy.  What resources does the firm have to draw on to meet those more-or-less well known short term cash demands?

Side note.  The need for cash doesn't in general need to be short term, but that is clearly the most pressing end of the timeline.  The immediate future is the period which most rapidly becomes 'now' and 'now' is when a creditor may declare its dissatisfaction with the borrowing firm.

The firm has cash and cash equivalents.  Some of this is considered operating cash - money in the till, to use a shop-keeping analogy.  This cash in a sense needs to be there for the smooth operation of the day to day business of the firm.  But in an emergency this might be considered a pot to be raided.  If the company is prudent, it will also have cash and near cash reserves (certificates of deposit, short term sovereign securities).  A very conservative company might chose to have enough cash in these reserves to pay the next n months, but of course, the n months will pass, and that pot needs to be replenished.  The pot itself is depleted only in exceptional circumstances.  The downside of having too big a pot of cash and cash equivalents is that it is capital sitting earning not much more than a risk free return.  And firms have as a goal the desire to produce a return on equity in excess of the risk free rate.  Otherwise why would an investor invest in a firm in the first place?

So, assuming a new demand for cash materialised, where else might the firm look?  Perhaps new loans or new bonds.  Perhaps a rights issue (a request from current and potential equity investors to give the company cash in return for ultimate fractional ownership in the company).  Perhaps cost savings.  Perhaps the shuttering of certain projects, with concomitant staff reductions.  Perhaps the sale of certain assets in the market - plant, financial securities.  Perhaps the monetisation of some fraction of its asset base.  But as you can imagine, all these options take time, and perhaps some mark down on sale prices - after all, the market might perceive the firm as executing a fire sale, so might be tempted to offer fire-sale prices.

This misalignment of (potentially immediate, potentially short term) demands for cash with (somewhat longer term) supply is what is known as a liquidity mismatch.  

If you think about it, to say that a firm is experiencing a liquidity problem in the first place is to identify a more or less dramatic liquidity mismatch.  So in a sense most liquidity problems are liquidity mismatch problems, and the word liquidity can often be considered as a synonym for a liquidity mismatch problem.

In case 2, the multi-strategy hedge fund, there is a little stub of a management company managing a potentially much larger pool of investments on behalf of investors.  The management firm itself, often a partnership, received equity investment by founding partners, who are said to have committed their cash for the long(-ish)term.  It will have well understood staffing costs and fixed costs.  In some ways, the investment management firm is a bit like 'head office' for a large goods manufacturer, but without the regional factories, offices, large staff, input supply chains, etc.  So the cash flows of the management firm are somewhat clearer.  Also those management firms might have loans but they won't typically be as well developed as with non-financial firms.  For multi-strategy hedge funds, the 'work' happens in the collection of financial assets and liabilities within its fund(s).  These investors in the fund can be flighty, and prime brokers can also adjust the generosity of their leverage terms.  Both of these create the possibility of a liquidity demand.  The fund manager only has the set of assets and liabilities in the fund to supply this needed cash.  So for them asset liquidity modelling and funding liquidity are important, as are a full incorporation of the set of firm constraints on liquidity scenarios.  And where it is unrealistic to fully model the constraints, to approximate them very conservatively.

Despite the seeming differences, both firms managing the possibility of liquidity mismatch are doing the same thing, namely being continually responsive to the balance between demands for cash with sources of cash.

In the next posting I look at the variance (and vol. of vol.) on the demand side of the 'liquidity mismatch' risk which firms of all kinds face.

Liquidity in context - II

Last time I was thinking about funding liquidity and had in my head the multi-strategy hedge fund.  The two primary demands for cash come from prime brokers, who might offer less favourable leverage terms to the hedge fund, which would manifest itself as a demand for more cash to be deposited with them for a given set of holdings on the hedge fund's book at that PB.  The fund would then stump up more cash or gross down their set of holdings.  The second demand is if a significant number and weight of investors in the fund decided, subject to their gates, to redeem their investment.  Th.is is either going to be funded out of the hedge fund's cash (or cash equivalents) bucket or it will make them sell some of their assets and liabilities.  Which brings me on to ...

Asset Liquidity. (Or more strictly speaking, bottom up asset liquidity).

A firm owns a number of units of some security.  The 'asset liquidity' question arises about that holding.  The form of the question is always one of T|CF, C|TF or F|C,T and the source of the answer comes from (1) two facts about the firm and (2) a set of facts about the market for that security.  

The primary firm fact is the position size.  The secondary fact is which collection of constraints are apposite for the liquidation of that asset.  The constraints impose costs (financial, time, fraction) on the unwind.

The market facts are more numerous.  Measuring a market's liquidity is a large subject and the set of data to come to an opinion about its current liquidity is probably asset type and market-specific.  But in general they are statistical reads on the market.

The final piece of the puzzle is how to codify the various statistical reads on the market to produce a liquidity response curve for that market at that time.  Actually, it is not a 2D curve but a 3D surface, with the primary independent variable being F*E, the fraction of the fund's holding of this security being targeted in the liquidity scenario at hand, multiplied by the exposure, E this firm  has to the asset (in simple cases, its quantity).  The surface exists for every exposure point.  In the most general case, the set of curves would extend into negative exposure values for F*E, allowing for asymmetric markets.  The slightly  simpler case is to assume the market is symmetrical and the sign of the exposure is not important.

Whilst in theory all those response curves exist, for any given day, you may only be interested in a single one of them, namely the curve associated with the F*E value in play on that day in your firm.

Usually, either the cost threshold is a parameter of the liquidity run, or the time threshold is given.  In this case, the surface becomes a curve.  E.g. Time(F*E|F=100%, C<1%)  - a safe and compete wind down curve / asset liquidity estimate.  Cost(F*E|F=50%,T=3d) - a drop dead target of 3d to reduce the holding size by half.  Both of these are asset liquidity estimates.

Think of the cost and time curves both in terms of the absolute cost (EUR) or time (days) for a position of size F*E to be unwound, in which case this is an upward sloping convex curve of some sort or another; or think of the cost as a cost per unit, in which case its convexity is fully explained by the expect saturation cost associated with bringing a larger and larger fraction to market.  Very liquid markets have a flat per-unit response curve both for time and cost.

I will call these per-unit response curves lower case $t_m(F_s \times E_f|F_s,C_s,n_s)$ where $m$ stands for a market object, $s$ being a liquidity scenario parameter and $f$ being a fact of the firm and $n_f$ being the collection of firm unwind constraints.  Likewise the second of the possible asset liquidity measures is $c_m(F_s \times E_f|F_s,T_s,n_s)$.

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.

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.

Liquidity

Liquidity refers in several different ways to the degree to which a person or organisation can transform securities of one type into securities of a more generally or widely accepted type.  This sounds vague, but I wanted to start my examination of liquidity by stating it thus.  

Next, I'd like to point out that any security in the world can be liquid at one moment and then later can be illiquid.  Third, I'd like to state that liquidity can be considered a ranking measure applied to all assets, from most to least liquid and that this ranking is context dependent.

The context can be time-specific (what now is liquid may not be liquid tomorrow; what now is illiquid may later be perceived as liquid), market-specific (the market associated with a particular security can have its own liquidity measures), holder-specific (what may be liquid to you because you only own one unit may be dramatically less liquid for me, if I own a large fraction of the amount outstanding of the security) and scenario-specific (holdings may be considered liquid under certain 'normal' market conditions by simultaneously less liquid under others - e.g. in a forced sale).  In this last case there is sometimes a real need or an imagined need to perform the transformation to perform some obligation.  Two examples of this are when a bank run occurs and the institution struggles to transform its assets back into cash to meet lender cash requirements; and when investors in hedge funds demand the return of their capital or regulators of those hedge funds demand to see how the manager could plan to liquidate its assets under management in a way which satisfies investor demands.

Finally, in estimating the liquidity of an entity's set of holdings, there may or may not be any additional liquidity constraints in place, which would alter the liquidity profile of those assets - I'm thinking here of clauses in hedge fund offering memoranda to investors which aim to remain fair of the average investor at all points during a forced unwind.

At its most general, liquidity is a relative measure between two arbitrary securities.  But, rather like the extension of the capital asset pricing model by Sharpe to the concept of a correlation between a security and the market index, it is convenient to consider all of these relative liquidity reads to be between the security in question and the single most liquid instrument, often considered to be cash in the local currency of interest.

One perfectly acceptable result of a liquidity analysis is a simple ranking of securities where the ranking is in effect for a known period of time.  Another is an arbitrarily scaled measure, with 0 occupying the value associated with the currently most liquid security.   This is like the ranking approach, but with the distances between securities having a common method of interpretation.   These two can be applied at the level of the market.

A third, appropriate only at the holding level, per security, would be a quadruple of fraction sold, time period, percentage cost (what fraction of the asset value will be lost in performing this transform at this time and in this size), constraint set (which a common theoretical target liquidity asset being cash in the local currency).  Let me explain all  four parts.

For a given constraint set (e.g. the company needs to raise 1,000,000 GBP in the next 4 weeks to meet a bond coupon payment; a hedge fund needs to satisfy an investor stampede to the exits, which means that a gating schedule sets up a demand schedule for cash over the coming 6 months), a company can examine its holding set and decide to fix two of the three remaining dimensions, and examine the effect on the third.  It could, for example fix the fraction sold to be 100% and the percentage cost tolerance to be <1% then see how long it would take to sell all the holdings of the asset.  It could, alternatively, hold the time to be <1d and the fraction to be again 100% and see just how much the percentage cost tolerance increases.  Thirdly, it could keep the cost tolerance at <5% and the time to be <1d to see how much they could sell of their holding set.

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.