Liquidity liquidity everywhere but not a drop to drink

One of Gustave Doré's illustrations of The Rime of the Ancient Mariner, plate 4

The minsicule bid ask spreads we see in financial markets today indicate that stocks and bonds have never been more liquid. At the same time, skeptics worry that the odds of a sudden evaporation of this liquidity has never been higher. This Jekyll and Hyde world of ultra liquidity coupled with heightened risk of liquidity famines is one of the core themes running through a great series of posts on market liquidity from Liberty Street, the NY Fed's blog. See here, here, and here.

To protect their portfolios, investors need to be able to look beyond the incredible amounts of potentially superficial liquidity coursing through markets and plan for future illiquidity crisis. For this sort of preparation to be possible, what investors really need is a market in long-dated liquidity-related financial products.

Central banks have historically been the chief providers of liquidity-related financial products, namely liquidity insurance, or the guaranteed use of central bank lending facilities in a crisis. The problem, as Stephen Cecchetti and Kermit Schoenholtz point out, is that we simply don't know if central banks are offering this financial product at the right price and in appropriate quantities. Cecchetti & Schoenholtz say that providing lending facility access: 

without limit and without penalty can lead to enormous moral hazard, causing overreliance on the central bank. If market participants are trained to ignore liquidity risk in good times, they will do little to make markets less fragile or to prepare themselves for unanticipated, but persistent episodes of market illiquidity.

The other problem is that central banks only provide liquidity insurance to banks. What about the rest of us? How can all investors, and not just bankers, benefit from properly priced liquidity insurance products?

---

A central bank is a monopolist without much business sense. It has no idea how to set the proper price for insurance products. Which is why I think a private market in liquidity options, or liquidity insurance, may be an ideal solution.

How might these liquidity options look?

An option to sell at the ask price

In financial markets there is a price at which participants are willing to buy and a price at which they are willing to sell. This is the famous bid-ask spread, or bid-offer spread.

Say the bid, or buying price, for Google shares is $650 and the ask price is $660, the width of the spread being $10.

A seller with time on their hands will join the queue of sellers already at $660 and wait for a buyer to step forward. If the seller is desperate for liquidity, they will sell at $650 to the first buyer in the bid queue, absorbing the $10 loss. When a liquidity crisis hits, this spread may widen out such that a desperate seller will only be able to get out at $640, or $600.

Liquidity risk can be thought of as thusly: We'd all love to rapidly sell at the offer, or ask price, but reality forces us to trek the distance across the spread and sell at the bid. In normal times, who cares; the spread is miniscule. But this trek-to-the-bid gets much costlier in a crisis when spreads widen out.

A liquidity option would be designed to allow investors to do the impossible: sell rapidly at the offer price. Using the Google example from above, an investor who buys a Google liquidity option would be allowed to exercise the option and immediately buy Google from the option seller at the current market offer price, say $660, and not the bid price, say $650. If buyers were to flee and liquidity evaporate such that the level of bids falls to $600, the owner of the option is protected since they can sell Google at the offer price of $660, and not the much lower bid price of $600.

Think about it this way. Whereas a regular put option provides downside price protection by allowing the owner to sell at a fixed price, a liquidity option allows them to sell at a fixed spread. Buying liquidity protection for one Google share would probably be much cheaper than getting downside price protection for that same share.

What should the price of a liquidity option be? Say that the difference between Google's bid and ask is typically $10. An insurance writer who is is required to purchase Google from the option owner at the offer price can typically only offload this risk by turning around and selling Google at a $10 loss. They will therefore require an initial insurance payment, or premium, of at least $10 to compensate.

When a liquidity crisis hits the current bid-ask spread will widen and insurers will ask for higher premiums on newly issued insurance. If current liquidity stays healthy but the odds of future liquidity crisis increase such that future Google bid-ask spreads are expected to be quite wide, then the liquidity insurance writer will require more compensation as well. The value of a liquidity option depends on both current and expected illiquidity. Conversely, if liquidity risks are expected to decline, buyers will ask for lower premiums since they don't expect the insurance to offer much protection over its contract life.

Those investors who have hedged against liquidity risk by buying liquidity options need never fear illiquidity again. If liquidity stays healthy their liquidity options will expire worthless but they'll have no problems exiting their positions. If liquidity deteriorates they can no longer exit their positions directly by selling on the market but can just as easily get liquid by exercising their options.

In addition to Google, a well designed liquidity market would have liquidity options on all major equities, ETFs, and widely traded fixed income products. Full democratization of liquidity insurance would be achieved by having these options trade on public markets. Information about the price of liquidity would become widely available so that investors could "internalize liquidity risk", as Cecchetti & Schoenholtz put it. If they didn't like the risks they found themselves facing, investors could use these products to reorient themselves. Take a family with a mortgage that was too afraid to buy Google because of the potential for an outbreak of illiquidity at the same time that a mortgage payment comes due. The can now own shares and hedge away their liquidity risk by purchasing a liquidity option. Folks like Warren Buffett, a conservative investor with a strong balance sheet capable of withstanding liquidity crisis, would be able to earn extra income by writing liquidity options and collecting premia.

In sum, with a well designed liquidity options market, the risks of illiquidity are distributed to those who want to bear them and away from those who don't. Markets will probably be much less fragile. As for central banks, with the market providing both liquidity insurance and liquidity pricing, central bankers can focus much more on what they should be doing; monetary policy.

Fear of illiquidity

There are thousands of fears, from arachnophobia to globophobia (fear of balloons) to zoophobia (fear of animals). What might the fear of market illiquidity look like?

Say that you are petrified that a day will come when markets will be too illiquid for you to convert your wealth into the things you need. There are two ways for you to buy complete peace of mind.

The first strategy involves selling everything you own now and buying checking deposits, the sine qua non liquid asset. Get rid of the house, the bonds, the stocks, the car, your couch, and your books. Use some of the proceeds to rent a house and a car, borrow books, and lease furniture. In renting back the stream of consumption benefits that you've just sold, your level of consumption stays constant. Negotiate the rental arrangements so that the lessor—the owner—cannot cancel them, and so that you can walk out of them at a moment's notice. Structuring things this way ensures that rental obligations in no way inhibit your ability to stay liquid. With your hoard of highly liquid deposits and array of rental agreements, you've secured a state of perfect liquidity. Relax. Breathe in. Enjoy your life.

The second way to perfectly hedge yourself from illiquidity risk would be to buy liquidity insurance on everything you own. For instance, an insurer would guarantee to purchase your house whenever you want to sell at the going market price. Same with your stocks, and bonds, your car and couches and your books. With every one of your possessions convertible into clean cold cash upon a moment's notice thanks to the insurer, you can once again relax, put your legs up, and lean back on the couch.

Since both strategies lead you to the same infinitely liquid final resting place, arbitrage dictates that the cost of pursuing these two strategies should be the same. Consider what would happen if the liquidity insurance route was cheaper. All those desiring a state of infinite liquidity would clamor to buy insurance, pushing the price of insurance higher until it was no longer the better option. If the checking deposit/rental route was cheaper, then everyone would sell all their deposits and rent stuff, pushing rental prices higher until it was no longer the more cost-efficient option.

Now I have no idea what liquidity insurance should actually cost. But consider this: liquidity option #1 is a *very* expensive strategy. To begin with, you'd be forgoing all the interest and dividends that you'd otherwise be earning on your bonds and stocks. Checking deposits, after all, offer no interest. Compounded over many years, that comes out to quite a bit of forfeited wealth. Second, you'd have to rent everything. And the sort of rent you'd have to negotiate would be costlier than normal rent. Last time I checked, most landlords require several months notice before a renter can be released from their rental obligation. But the rental agreements you have negotiated require the owner to accept a return of leased property whenever *you* want—not when they want. And that feature will be a costly one.

Since option #1 is so expensive, arbitrage requires that option #2 will be equally expensive. Let's break it out. Option #2, liquidity insurance, allows you to keep the existing flows of income from stocks and bonds as well as saving you from the obligation of paying high rent (you get to keep your house and all the other stuff). Not bad, right? Which means that in order for you to be indifferent between option #1 and #2, the cost of insurance must be really really high. If it wasn't, everyone would choose to go the insurance route.

So who cares ? After all, liquidity insurance doesn't exist, right? Wrong. Central banks are significant providers of liquidity insurance. They insure private banks against illiquidity by promising to purchase bank assets at going market prices whenever the bank requires it. This isn't full and complete liquidity insurance— there are a few assets that even a central bank won't touch—but it's close enough.

The upshot is that banks are well-protected from illiquidity. They get to keep all their interest-yielding assets and at the same time can rest easy knowing that the central bank insures that those assets will always be as good as cash. Consider what things would be like for private banks if the central bank were to get out of the liquidity insurance business. Now, the only way for bankers to replicate central bank-calibre liquidity protection would be for them to pursue option #1: sell their loan books and bond portfolios for 0%-yielding cash. But then they'd be foregoing huge amounts of income. They might not even be profitable.

With logic dictating that the cost of buying liquidity insurance needs to be pretty high, are modern central banks charging sufficiently stiff rates on liquidity insurance? I'm pretty sure they aren't. Regular insurers like lifecos require periodic premium payments, even if the event that said insurance covers hasn't occurred. But the last time I read a bank annual report, there was no line item for liquidity insurance premiums. It seems to me, and I could be wrong, that central banks are providing liquidity insurance without requiring any sort of quid pro quo. Feel free to correct me in the comments section.

Say that I'm right and that central banks are providing private banks with underpriced liquidity insurance. Central banks are ultimately owned by the taxpayer, which means that taxpayers are providing private banks with artificially cheap liquidity insurance. And that's not a fair burden to put on them. Nor is the underpricing of insurance a good strategy, since it results in all sorts of institutions getting insurance when they don't necessarily deserve it.

Does anyone know if central banks have any sort of rigorous model for determining the price they charge for liquidity insurance. Or are they just winging it? ... it sure seems like it to me.

A visual review of the lending facilities created by the Fed during the credit crisis

I'm currently updating my History of the Fed chart. As a side project, here's what's happened to the various Federal Reserve credit programs initiated during the crisis. Most of them have rolled off the Fed's balance sheet. Even the most toxic of them - Maiden Lane I and III - seem set to be paid off.

Go to scribd to see a higher resolution pdf. Alternatively, my public gallery has a high-res GIF.

This chart illustrates one role of a central bank, that of lender of last resort role. A central banking facing a crisis is supposed to lend to everyone on any sort of collateral and buy all sorts of assets. If you read through the fine print of the chart, you'll see that the Fed's new facilities accepted a broad range of assets - from commercial paper to CDOs to RMBS, and opened themselves up to a fairly wide array of counterparties.

What is really happening here is that the Fed is providing liquidity insurance. Liquidity insurance is like any other form of insurance - home insurance, car insurance, credit default insurance, whatever. Given the possibility of a fire, people buy house insurance to compensate  for that outcome. Given the possibility that one might be required to do a fire-sale into a thin market, it might be a good idea to purchase liquidity insurance ahead of time. Both are products that can be provided by insurance companies competing in the market.

Unfortunately the Fed can never know if it is providing liquidity insurance at the right price because it is the monopoly provider and has no competition. During the credit crisis, a lot of firms were extended liquidity insurance by the Fed even though they never paid for it ahead of time. In the future, one would hope that the free market takes over the Fed's role of liquidity insurance provider, leaving the Fed to operate the clearing system and set a few interest rates.

The free banking alternative to the centralized provision of lender of last resort services

Inspired by Perry Mehrling and Fischer Black:

I think I'd take your future ideal financial model even further (slide 9). The C5 in your model provides what you call liquidity puts. I see no reason why these liquidity puts need be provided by a central bank. In the future, financial products called liquidity options - the option to buy or sell some asset (say Apple stock) at a guaranteed point in the bid-ask spread - would be popular financial products traded on organized exchanges. Just as Apple CDS allow investors to split off Apple credit risk and distribute it across the economy, so would Apple liquidity options split away the liquidity risk of transacting in Apple stock in the secondary market and evenly distribute this risk to those willing and capable of holding it.

A private liquidity options market has some advantages over a monopoly last resort system. Liquidity would be competitively priced and no longer supplied in an opaque manner. Central banks would either vacate the market for liquidity services or price their liquidity products off the private liquidity options market. Subsidies to or penalties on institutions anxious for liquidity insurance would be a thing of the past.

If central banks were to cease providing liquidity options, their sole role in the future would be as managers of the clearing and settlement system. The provision of paper money can be easily fulfilled by private banks. I guess central banks would also have to manage the price level.

The above is a free-banking view of the world. The lender-of-last resort role is transferred from central banks to private markets. It is distilled into just another financial product.

Did the Canadian government subsidize the big banks? The problem with pricing liquidity

Nick Rowe had a good comment on the CCPA's recent allegation that Canada's big banks were subsidized by taxpayers. In the comments I pointed out the difficulty of determining whether a subsidy or penalty had been paid to the banks because we lack a way to properly price and therefore compare the provision of liquidity services.

In effect, a government program called the Insured Mortgage Purchase Program (IMPP) announced it would buy $125 billion worth of insured NHA-MBS from the banks. It eventually bought $69 billion worth. In an alternative world, the same result is arrived at when

NHA-MBS liquidity options are sold by private actors to holders of NHA-MBS. These options allow NHA-MBS holders to sell all MBS back to the option writer at any time at a liquidity-protected price (some favourable point in the bid-ask spread). In a liquidity crisis bid-ask spreads increase, so the value of these options would quickly rise. The CMHC/IMPP provided MBS holders with a liquidity option, but we'll never know if they required MBS holders to pay the market price for this option.

Hey Nick, am I making any sense here?

Fisher Black's dream

Perry Merhling had an interesting quote from Fischer Black:

Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk; and one would bear the risk of default. The last two would not have to put up any capital for the bonds, although they might have to post some sort of collateral

In the comments I pointed out that a fourth person can be added to the list - someone who bears the liquidity risk of that corporate bond in the secondary market. This would amount to a liquidity option. Essentially, the bearer of liquidity risk would allow the bond owner to sell that bond at some preset level in the bid-ask spread. For instance, the option could allow the bond owner to immediately sell their entire bond holdings at the upper end of the spread, or at the ask price. Normally, sellers can only sell quickly if they accept a price near the bid price, or lower end of the bid-ask spread. When illiquidity strikes and spreads widen, usually because buyers depart and there are less bids, an option to sell at the ask price rather than the bid price increases in value.

If Iceland were to adopt the Canadian dollar

Nick Rowe brings up the topic.

There are plenty of interesting comments there on how this would work. In particular, how would the Icelandic banks secure liquidity if they were to move to a Canadian  dollar standard? It seems to me that local Canadian banks could act as lenders of last resort to the Icelandic banking system.

Alternately, if Icelandic banks were willing to submit to Canadian regulation, then perhaps things could proceed one step further and get admittance to the Canadian Payments Association, Canada's central clearing system. As members they would get Bank of Canada lender of last resort assurance.

Bagehot, Liquidity Insurance, and LOLR

Commented at Macromania on "On Bagehot's Penalty Rate".

 I think you have captured an inconsistency in the Bagehot principle. If the guiding rule is to lend at a penalty rate, then during a liquidity crisis how can the central bank ever fulfill its duty as lender of last resort? The rate that the market requires will rise but the penalty rate will rise even more, such that the central bank effectively prices itself out of the market. After all, if you can transact with the market at x%, why transact at x+1% with the LOLR? Some liquidity provider that is.

 At the same time, I'm sure we can all agree that the job of a LOLR is to provide liquidity, not set market prices.

 I think the problem here is that we haven't learnt how to properly understand and measure liquidity, and therefore can't price it and provide adequate liquidity insurance policies. Central banks certainly aren't great at it. Because their tools are so blunt, as an unfortunate by-product of acting as LOLR they clumsily prop up asset prices. And that gets everyone angry, and justifiably so.

 The best solution would be to devolve the provision of liquidity insurance to the market. Financial products would be developed to provide superior measures of liquidity, and the prices of liquidity for various assets would become public. Taxpayers would no longer have to worry about subsidizing sloppy efforts to provide liquidity to those who may not have paid the market price for the benefits the Fed provided them.

Some relevant links:

Liquidity Options by Golts and Kritzman
Liquidity and risk: liquidity as the value of an option to sell at the market price at WWCI (see bob's comments in particular)