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?

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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.

An ode to illiquid stocks for the retail investor

Today's go-to advice for the small retail investor is to invest in passive ETFs and index funds. These low cost alternatives are better than investing in high-cost active funds that will probably not beat the market anyway. There's a lot of good sense in the passive strategy.

Here's another idea. If you're a small investor who has a chunk of money that needs to be invested for the long haul, consider investing in illiquid stocks rather than liquid stocks, ETFs, or mutual funds. Pound for pound, illiquid stocks should provide you with a better return than liquid stocks (and ETFs and mutual funds, which hold mostly liquid stocks). Because you're a small fish, you won't really suffer from their relative illiquidity, as long as you're in for the long term. Here's my reasoning.

Take two companies that are identical. They begin their lives with the same plant & equipment and produce the exact same product. Say the risks of the business in which they operate are minimal. They will both be wound up in ten years and distribute all the cash they've earned to shareholders, plus whatever cash they get from selling their plant & equipment. The price of both shares will advance each year at a rate that is competitive with the overall market return until year 10 when the shares are canceled and cash paid out.

The one difference between the two is that for whatever reason, shares in the first company, call it LiquidCo, are far more liquid than shares in the second, DryCo. LiquidCo's bid-ask spread is narrower, it trades far more often, and when it does trade the volumes are much higher.

Given a choice between investing in two identical companies with differing liquidities, investors will always prefer the more liquid one. This is because liquidity provides its own return. Owning a stock with high volumes and low spreads provides the investor with the comfort of knowing that should some unforeseen event arise, they can easily sell their holdings in order to mobilize resources to deal with that event. The liquidity of a stock is, in a sense, consumed over its lifetime, much like a fire extinguisher or a backup generator is consumed, though never actually used. The problem with illiquid stocks, therefore, is that they provide their holders with little to consume.

As a result, the share prices of our two identical firms will diverge from each other at the outset. Since shares of LiquidCo provide an extra stream of consumption over their lifetime, they will trade at a premium to the DryCo shares. However, both shares still promise to pay out the exact same cash value upon termination. This means that as time passes, the illiquid shares need to advance at a more rapid rate than the liquid shares in order to arrive at the same terminal price. See the chart below for an illustration.

The logic behind this, in brief, is that illiquid shares need to provide a higher pecuniary return than liquid shares because they must compensate investors for their lack of a consumption return. This higher pecuniary return is illustrated by DryCo's steeper slope.

Here's where small retail investors come into the picture. Because the capital you're going to be deploying is so small, you can flit in and out of illiquid stocks far easier than behemoths like pensions funds, mutual funds, and hedge funds can. From your perspective, it makes little difference if you invest in LiquidCo or DryCo since your tiny size should allow you to sell either of them with ease. Your choice, therefore, is an easy one. Buy Dryco, the shares will appreciate faster! Thanks to your minuscule size, the market is, in a way, giving you a free ride. You get a higher return without having to sacrifice anything. In short, you get to enjoy a consumer surplus. [1]

Put differently, the consumption return provided by LiquidCo is simply not a valuable good to you as a small and nimble investor. By holding LiquidCo, you're throwing money away by paying for those services. Rather than enjoying a consumer surplus, you're bearing a consumer deficit by holding liquid shares, perhaps without even realizing it. [2]

This advice is of little use to large fish like mutual funds and hedge funds. These players never know when they will face client redemptions necessitating the liquidation of large amounts of stock. Investing in illiquid shares poses a very real inconvenience for them since they are likely to be punished if they try to sell their illiquid portfolio to raise cash to meet redemption requests. Paying the premium to own liquid shares may be the best alternative for a large player.

Because they dominate the market, large players are largely responsible for determining the premium of liquid shares over illiquid ones. Retail investors who directly invest in stocks have become a rare breed, typically opting for mutual funds or ETFs. As such, the premium doesn't reflect retail preferences at all, but the preferences of larger players. Liquid stocks are well-priced for institutional investors but mispriced for the retail investor.

Look over your portfolio. Are you mostly invested in liquid stocks? If so, you may be paying for a flow of liquidity-linked consumption that you simply don't need. Do you hold a lot of mutual funds and ETFs? Both will be biased towards liquid stocks. Mutual fund managers need the flexibility of liquid shares to meet redemptions, and ETFs are usually constructed using popular indexes comprised of primarily liquid stocks. If your liquidity position is overdetermined, it may be time to shift towards the illiquid side of the spectrum. The tough part, of course, is finding what illiquid stocks to buy. But that's a different story.

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[1] For this strategy to work in the real world, you really do need to be holding for the long term. My chart shows a steady upward progression. But in the real world, there will be hiccups along the way, and when these happen, illiquid stocks will tend to have larger drawdowns than liquid stocks, even though the underlying earnings of each firm will be precisely similar. As long as you don't put yourself in a position that you're forced to sell during temporary downturns, then you should earn superior returns over the long term.

[2] This is why I like the idea of liquidity options, or "moneyness markets". It makes sense for retail investor to buy LiquidCo if they can resell a portion of the unwanted non-pecuniary liquidity return to some other investor. That way the retail investor owns the slowly appreciating shares of LiquidCo and also earns a stream of revenue for having rented out the non-pecuniary liquidity return. This combination of capital gains and rental revenues should replicate the return they would otherwise earn on DryCo. See this post, which makes the case for "moneyness markets" for the value investor (and helpful comment from John Hawkins).

TIPS: How to decompose the liquidity premium from the inflation-risk premium

Lars Christensen talks about the idea of setting a floor under inflation-linked bonds in order keep inflation expectations at some minimum level. It`s an interesting idea. Here is my comment:

Interesting idea, Lars. One problem here is that the TIPS spread (I’ll use US lingo if you don’t mind) measures not only expected inflation but also the relative illiquidity of TIPS relative to Treasuries. It measures, in part, a liquidity premium.

TIPS might fall to the central bank’s minimum buying price not because inflation expectations have fallen, but because the liquidity of TIPS relative to Treasuries has declined. This change in liquidity could be purely incidental. ie. it could be due to some unimportant technical change unique to Treasury markets. The result would be that the central bank buys up TIPS because it believes inflation expectations have fallen, when in actuality it is the liquidity premium that has changed. According to your rule, the money supply automatically increases, though perhaps it shouldn’t have.

In short, you have to find some way to decompose that portion of the spread between TIPS and Treasuries that is due to the liquidity premium and that which is due to inflation expectations.

It there were publicly traded “liquidity-options” on TIPS, you’d be able price the value of the liquidity premium and use that to back out that portion of the TIPS spread due purely to inflation expectations. Then you could apply your rule more precisely.

In a 2009 speech, FRBNY President William Dudley talks about the illiquidity premium and inflation-risk premium of TIPS here.

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.

Money as a liability

Nick Rowe has posts here and here that explain why money is not a liability. This is related to his point that  money is not a store-of-value.

I have several comments on each thread.

In short, I disagree with him. If you do the security analysis, central bank issued notes and deposits are unsecured senior perpetual liabilities with a limited floating conversion feature attached to them. Most people don't perceive them as such because in the normal course of life they only experience these liabilities as pure means-of-exchange. Only those individual's with a banker or investor's mentality treat central bank issued notes and deposits. Either way works - what is interesting is how these two mentalities weave together to create an integrated store-of-value and medium-of-exchange approach to understanding money.

Nick also tries to re-conceptualize central bank issued money as put options. This money can be "putted" for CPI. I like this idea. Because I see central bank issued notes and deposits as liabilities, I prefer the analogy to convertible bonds. Convertibility is really just an option feature added on to a liability like a bond, deposit, or note. How does this convertibility work?  The Bank of Canada, for instance, will conduct sale and repurchase operations (SRAs) - selling bonds for cash - should the overnight fall below its target. Banks have the option in this case to convert their deposits into the underlying. This is a floating rate because over time the Bank will change the note-to-bond conversion price.

Moneyness and liquidity options

Lars Christensen had an interesting post on moneyness and the Divisia indexes. He recommended an old paper of Steve Horowitz's which I read some time ago and have always respected. See A Subjectivist Approach to the Demand for Money.

Essentially, you can't believe in the concept of moneyness and also believe in the effort to count money through indexes like M1, M2, or even the Divisia indexes. The two efforts contradict each other. The best way to get a market indication of moneyness, or liquidity, is through the introduction of liquidity options. My comment follows:

If moneyness is a subjective concept, and I think it is, then trying to sum up various money assets into a Divisia index is problematic. That’s because an asset that appears to be high on one person’s subjective moneyness scale will be low on another’s, the result being that it is impossible to create objective categories for moneyness.

Ultimately, the best way to determine moneyness is to back out the market’s assessment of an asset’s liquidity premium. The best way to do this is to introduce liquidity options on various assets and see how the market prices these options. Anyways, this is science fiction for now since liquidity options don’t exist.


Previous posts on liquidity options.

Liquidity options, liquidity premium, natural interest rate, TIPS, and inflation swaps

Commented on David Glasner's Once Again The Stock Market Shows its Love for Inflation:

The only problem here is the one that we talked about in a previous post (Unpleasant Fisherian Arithmetic) concerning the liquidity premium that assets carry. The reason for the rising TIPS spread could be (though not necessarily must be) that the liquidity premium on treasuries is shrinking relative to that of TIPS, and therefore TIPS are rising in price relative to Treasuries. This makes it hard to pass judgment on the hypothetical rate of return on capital.

 Anyways, you have already commented on this problem in your paper: “One possible cause of distortion in the yield on TIPS bonds and in the TIPS spread during the autumn 2008 financial crisis is that the yield on conventional Treasuries was depressed because of a liquidity premium. Even though the ex ante real interest rate was likely negative, because TIPS bonds were perceived as much less liquid than conventional Treasuries, TIPS bonds could not be sold unless they were discounted, so that their yields rose well above the (unobservable) ex ante real rate on holding real assets.”

 We were talking in the comments of the “Unpleasant Fisherian Arithmetic” post about how one could measure liquidity. I thought a bit about this. If there were a market for financial products, say options, that managed to price the pure value of an underlying asset’s liquidity premium, then you would be able to measure the value that the market placed on assets’ relative liquidity premiums and, from there, get a better idea for what portion of an assets total return is provided by an own-rate and what is provided by a liquidity premium. These sort of financial assets don’t exist, but if they did they would probably be sort of like credit-default swaps… more like liquidity-guarantee swaps.

Note that is follows from a previous comment I had concerning the impossibility of computing the natural rate of interest because liquidity interferes. See Unpleasant Fisherian Arithmetic

David responded:

Have you looked at how the Cleveland Fed tries to extract the inflation expectation from the TIPS spread?

I responded:

 I looked at it this morning. It seems to me that the Cleveland Fed is using alternative measures to extract inflation expecations given the problems posed by illiquidity in TIPS markets. They are including the inflation swaps market. In an inflation swap, one party pays a fixed interest rate, the other pays the inflation rate.

 Apparently swap markets didn’t suffer as much as TIPS markets did from liquidity problems in 2008, and for that reason the Cleveland Fed is using swap rates as one of their main indicators of inflation expectations.

 That being said, swaps are still traded contracts and bear some sort of liquidity premium, so it is still empirically impossible to back out a real rate without knowing what that premium is.

 For your records, here is the quote page for the 2 year USD dollar inflation swap spread: http://www.bloomberg.com/apps/quote?ticker=USSWIT5:IND

The Cleveland Fed discuss their methodology here. http://www.clevelandfed.org/research/workpaper/2011/wp1107.pdf

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)