The term liquidity has now become a puzzle and an irritant for many. Mr David Longworth, Deputy Governor of the Bank of Canada, has given a wonderful speech on the subject. He says there are 3 kinds of liquidity:
- Macroeconomic liquidity, which has to do with “overall monetary conditions,” including interest rates, credit conditions, and the growth of monetary and credit aggregates.
- Market liquidity, which refers to how readily one can buy or sell a financial asset without causing a significant movement in its price.
- Balance sheet liquidity, which refers broadly to the cash-like assets on the balance sheet of a firm (or household). For non-financial firms, balance sheet liquidity is often measured by the short-term liquid assets on their balance sheet. For banks, which must manage their liquidity very closely, balance sheet liquidity is reflected in a detailed breakdown, by maturity, of their assets and liabilities – especially those coming due in the short term. The ability of banks to fund themselves is often referred to as funding liquidity.
The common element in these concepts is that liquidity is the ability to obtain cash – either by turning assets into cash on short notice or by having access to credit. He focuses on the first two. How to measure the two?
The key indicators of macroeconomic liquidity, in terms of price, are the policy interest rates and the term structure of interest rates paid by borrowers. In terms of quantity, the key indicators are the growth of monetary and credit aggregates and the state of credit conditions more generally. In normal times, central bankers tend to place more emphasis on interest rates than on monetary and credit measures.
So, the liquidity which is managed by central bankers is macroeco liquidity.
Market liquidity refers to the extent to which one is able to quickly and easily buy and sell financial assets in the market, without moving the price. Market liquidity captures the aspects of immediacy, breadth, depth, and resiliency in markets. Immediacy refers to the speed with which a trade of a given size and cost can be completed. Breadth, often measured by the bid/ask spread, refers to the costs of providing liquidity. Depth refers to the maximum size of a trade for any given bid/ask spread. Resiliency refers to how quickly prices revert to fundamental values after a large transaction.
That is pretty well said. J
Hence, market liquidity has number of aspects and each one matters equally. There may be depth and breadth in the markets but there could be times when immediacy and resiliency may not occur, as it was the case in sub-prime crisis.
Generally speaking, the more liquid the market, the better. But there is an important caveat – if market participants come to expect that market liquidity will always be ample, and they acquire assets with the assumption that they can liquidate their positions quickly and at fairly predictable prices, they may end up taking on more risk than has been factored into the purchase price. And this could sow the seeds of a nasty correction in the event of a shock and a rapid decline in market liquidity. That said, liquidity is the lifeblood of markets.
Both forms of liquidity have been increasing over the years. Macroeco liquidity because of low interest rates world over. And what keeps interest rates low- high savings by emerging markets. Market liquidity has been low as bid-ask spreads have been low and low volatility in all aspects of financial markets.
Longworth adds it is because of new instruments, new players (hedge funds etc) and advances in tech that are responsible. He also suggests that Great Moderation and Globalisation are also important factors for increasing market liquidity. Then he looks at how liquidity played a role in recent crisis and Canada’s response to the same.
Read the whole thing. A nice primer.