Professor Michael Mainelli, Executive Chairman, The Z/Yen Group
[An edited version of this article first appeared as "Liquidity = Diversity", Journal of Risk Finance, Volume 9, Number 2, Emerald Group Publishing Limited (March 2008) pages 211-216.]
Sometimes it is fun to move from the specific to the general, commenting along the way about what a wonderfully intertwined world we inhabit and the various epiphenomena involved. The collapse of Northern Rock is one specific from which we can move along to the general credit crisis and beyond to liquidity in the abstract. Let’s look at some specifics:
by 2006 Northern Rock, a mid-size UK mortgage lender, captures 20% of UK new mortgages by doing what everyone has stated for two decades should be done – borrow on liquid global capital markets to give consumers great deals;
the UK financial community congratulates itself on a decade’s successful tripartite approach to regulation and monetary policy - a single regulator in the Financial Services Authority (FSA) that has consistently claimed it is not running a zero failure regime, an ‘independent’ central Bank of England, and HM Treasury handling national finances;
Northern Rock starts having liquidity problems;
everyone blames imported US credit crisis problems;
then everyone blames the tripartite approach to regulation (appearing on television to say they knew all along it would end in tears these past ten years, hmm);
then everyone knows what Northern Rock should have done – built a larger retail deposit base so it was less reliant on global capital markets.
So, the conclusion? Northern Rock’s mistake was to not take advantage of UK consumers on the deposit side where the costs of switching are enormous [Martin and Mainelli, 2003]. Strange. There are some niggling details, for instance, that Northern Rock was not so much securitising its mortgage book as setting up revolving credit, however, the initial specifics should generate some queasiness amongst risk professionals. There are some serious casualties from this collapse, such as confidence in the British government, UK deposit insurance and the separation of regulation from “lender of last resort”, i.e., the division in responsibilities between the Financial Services Authority and the Bank of England.
Interestingly, despite never running a ‘no fail’ regime, the FSA was accorded almost too much status. Perhaps it would have been better for the FSA to publicise the half dozen or so failures in the UK financial markets every year than to have all the chickens come home to roost in one go. Public ignorance of the risk of failure led to a conflict with the FSA’s objective of “maintaining confidence in the financial system”. The FSA itself became a single point of failure. It may be a mistake to put all your regulatory eggs in one basket – the FSA is tarnished by any single failure, whereas the plethora of entangled US institutions provides plenty of room for each to crow about its successes while sloughing off failures. On the other hand, the plethora of institutions reduces innovation and market attractiveness.
Then we move to some generalities being bandied about the credit markets:
oligopolistic credit rating agencies had become a single point of failure in the US credit markets;
through credit tranching, the credit markets had perverted the ‘flat’ distribution in any specific rating, e.g. AAA, such that all AAA credits were concentrated at the very low end of the confidence band, e.g. bunched at 95.0001% to 95.1000% certainty instead of being uniformly spread in a range from 95.0% to 100.0% certainty;
the credit rating agencies had conflicts of interest in both consulting and rating, with their consultancy work intensifying the bunching;
the credit rating agencies were not transparent, e.g., declaring their respective consultancy and rating fees [Mainelli, 2003];
the credit rating agencies’ methodologies were flawed and had insufficient data histories to rate credit [Onstwedder and Mainelli, 2000/2001].
So, the conclusion? Well, the US system required ratings for investment in order to make the US financial system safer by ensuring that certain public interest investors, e.g. public pension funds, were constrained in their investment strategies. So, safety led to hazard led to disaster. And it’s not over. Continued speculation includes:
Basel II risk weightings are based on credit ratings, so Basel II must be flawed and one solution is just to increase capital requirements for banks;
monoline, or credit enhancement, insurers are wobbly and could lead to more failures;
markets will have more fitful starts and seizures, leading to continued pricing problems and making mark-to-market problematic;
credit squeezes will lead to housing market collapses;
Asian savings must be accommodated in global markets, and their currencies delinked from the dollar, leading to further wobbles;
currency crises are inevitable;
bad news from banks will only eke out over a long period as banks announce write-downs strictly in line with each other, in order to avoid being singled out by shareholders for a fire sale.
Apparently we call this a “liquidity crisis”. More often than it should be, ‘liquidity’ is discussed in a way that is simply synonymous with monetary policy, private equity lending, credit derivatives or the yen carry trade. These Alice in Wonderland conversations with slippery meanings remind me of the liquid joke where a policeman stops a minister for speeding. The policeman smells alcohol on the minister’s breath and sees an empty wine bottle on the floor. The policeman asks, “Sir, what have you been drinking?” And the minister says, “Just water.” The policeman asks, “Then why do I smell wine?” The minister looks down at the bottle and says, “Good Lord, He’s done it again!” Perhaps the joke should be about a central banker chatting about the money supply.
The Financial Times was quite cutting [Financial Times, “Defining Liquidity”, 10 August 2007]. “Central bankers have drowned the world in it, oil producers are awash with it, while an excess of it distorts everything from treasury yields to the copper forward curve. Yet overnight this all-powerful force can vanish, causing markets to tumble. Is the word ‘liquidity’ at risk of joining ‘more buyers than sellers’ and ‘profit taking’ in the pantheon of vapid financial jargon? … The confusion begins when this sensible concept of liquidity is used as the explanation for falling markets. Investors’ shifting preferences for liquid assets are clearly important for prices. But the observation that prices have fallen because it is hard to execute an asset sale at the expected price is a tautology.”
The Bank of England developed, and publishes in its Financial Stability Report, a financial market liquidity indicator incorporating bid-ask spreads, return-to-volume ratios and liquidity premia. A continuing debate is whether, and how, to incorporate a wider view of asset valuation in controlling money supply than current consumer-price-index-biased views.
Another set of holes arises from what are called ‘dark liquidity pools’. Dark liquidity pools are backwaters, often overlooked pools of capital separate from the main trading markets. These pools can exist within a large financial institution or among a group of financial institutions trading outside public exchanges. A well-functioning market is one that provides efficient price signals through a ‘price discovery’ process, smoothes the exchange of ownership, and reduces the risks involved in transferring assets or rewards. Trading ‘off market’ is considered to be ‘parasitic’ on price discovery. Here, I’m afraid I can’t resist a little ditty of my own, based on Jonathan Swift’s construction around a flea:
So, financiers observe, small pools
suck larger pools’ liquidity;
yet tinier pools drain other drops,
and so on to aridity.
Professor Avi Persaud has very insightful and influential thoughts on liquidity, particularly his articulation of ‘liquidity black holes’. A physical black hole is a region of space formed from the collapse of a star, where gravity is so strong that nothing, not even light, can escape after falling passed the event horizon (the “edge” of the black hole). A liquidity black hole is a region in finance, where liquidity is falling so rapidly that nothing, not even a large financial institution, can escape after prices start to fall. Everything dries up. Avi says “a liquidity black hole is where price falls do not bring out buyers, but generate even more sellers.” Avi points out that this definition is easily falsified. Normal price falls do not increase sellers, they increase buyers, while in a liquidity black hole price falls cause an increase in sales flow. People pay close attention to the total volume traded as an indicator of confidence in a market. This is rather strange as one can easily imagine that confidence in a market should lead to less trading. Perhaps the opposite of Avi’s liquidity black hole is the financial analogue of a supernova, a “liquidity white bubble”, where price rises do not bring out sellers, but generate even more buyers.
Liquidity black holes bear a strong resemblance to bank runs, where depositors seeking to take their money out of a solvent bank, which they perceive might fail, precipitate a crisis that attracts other depositors to withdraw their funds which leads to certain failure. “And when average opinion comes to believe that average opinion will decide to turn assets into cash, then liquidity may be confidently expected to go to zero.” [Janeway 2005] People head for the door, in German, Torschlusspanik. According to the FT, “When John Maynard Keynes described a “mania for liquidity” in 1931 – the US was running out of safe-deposit boxes – he meant it in this sense.” [Financial Times, “Defining Liquidity”, 10 August 2007] Naturally, the ones who precipitate the crisis have their cash, while the laggards are left penniless. As Brandon Davies points out, in a black hole “He who panics first, panics best”, while in a white bubble I say, “He who smugs first, smugs best.”
Trading on Ice
So, only liquid is solvent? There is an old phrase that “liquidity begets liquidity” meaning, simply, that once some people start trading, more people will join them. This phrase is often used to explain away monopolistic problems with exchanges. The assumption is that a successful, and beneficial, exchange will inexorably draw all relevant trading to its increasingly liquid market. Michael Milken said, “Liquidity is an illusion. It’s always there when you don’t need it, and rarely there when you do.” Most traders claim that more liquid markets are better than less liquid markets for everybody. Not surprisingly, while they last, liquid markets are better for traders. In liquid markets traders can conclude many deals with concomitant commission. In illiquid markets traders have fewer trades and more risk. However, a number of economists question the notion that liquidity is inherently good or bad. O’Hara summarises Keynes’, Tobin’s and Summers’ criticisms as “liquidity begets instability.” The ability to buy and sell easily might drive short-term markets and exacerbate market changes, i.e. inducing liquidity crises. At a recent City fund manager luncheon I heard that “old, overheating liquidity story”, which one assumes ends with all of finance boiling away. Liquidity is like most things, good in moderation, but bad in excess or deficit.
Persaud and others point out that there are a number of problems with the structure of today’s markets that do increase our susceptibility to liquidity disruptions:
interlinked global markets - liquidity problems now reverberate across markets and borders and there is greater correlation among asset classes;
more rigorous and regular benchmarking – constant appraisal induces people to track benchmark indices in similar ways and need to buy or sell at identical times;
regulatory rationalisation - common strategies, credit policies and margin requirements lead to similar sales frenzies to maintain capital adequacy;
information systems commoditisation – using similar analytics and computer systems increases the likelihood of similar trading strategies and investment approaches.
Our global system for the dispersion of risk, from credit agencies and pension funds to prime brokers and hedge funds, may contribute to creating too much liquidity which in turn leads to risk.
What might we recommend? Perhaps, not a lot. It’s a bit like one of Canute’s courtiers writing a policy document recommending the extermination of astral black holes, “first stop supernovas from forming…” Perhaps liquidity black holes are another immutable feature of the universe. As long as there are markets it is likely that there will be liquidity crises. Yet, not all is defeatism. I subscribe to the idea put forward by Persaud and others that increased diversity in financial markets would lower the risk of liquidity black holes. Investors would exhibit a range of behaviours, so sellers are more likely to meet buyers in part, and be more patient. In addition to stressing more work on control and measurement of the money supply, I would summarise some potential recommendations as:
heterogeneity – encouraging the broadest possible range of investors, from individuals, to corporates, investment managers, insurers, share clubs, gamblers or hedge funds, into multiple markets – this increases the odds of chance encounters as well as the odds of sticking things out;
measurement – a number of fractal measures or biodiversity indices could be researched to help investors distinguish a deep and diverse liquidity pool from a deep and homogenous one. I wonder if we can find better analogies for liquidity in measures such as digital television signal quality, pond life or quantum physics, from which we can measure choppiness, gaps and uncertainty, than some of the more common continuous physical functions;
market structures – some adjustments to market structures might reduce the risk of black holes, such as advanced encryption systems for anonymous and confidential trading, including the exchange of inventories and buy/sell intentions. I also wonder about encouraging markets where trading is done in a fixed size, e.g. one share at a time without large block/bulk trades and their price impact problems. Or even markets where trade orders are randomised in time and position before being matched.
At a recent dinner discussing Northern Rock, one commentator wanted to give a bunch of ‘grey panthers’, i.e., a bunch of retired brokers and market makers, a ‘license to lunch’, i.e. to get paid for snitching back to the regulators on irregularities. It is a rather appealing idea. Sadly though, the admission is that formal systems for openness and market transparency aren’t working, and returning to self-regulatory organizations or an ‘old boys’ club’ is better than the current segregation of regulation. Perhaps regulation itself is the problem? Until we introduce competition in regulation, e.g. regulation via standards markets & kitemarks, or competition between FSA & FSB, enormous gaps such as Northern Rock will always appear. Only competition will keep regulators on their toes. Regulators are no different to other workers. But the assumption that they are different leads us to exclude competition as a means of controlling them to achieve objectives. Yet it works everywhere else.
So what have we learned? We see that the characteristics of liquid markets are resilience, depth and tightness. We can visualize the idea of “discovering the supply and demand curves” – the curves may not be smooth, nor continuous; they may have a wide band of uncertainty. In normal circumstances, liquidity risk = the odds of being surprised that the supply or demand curve isn’t where you thought. We also know that black holes and white bubbles fundamentally change the nature of liquid markets – where sellers draw in more sellers, or buyers draw in more buyers, the price drops, or rises, precipitously. Finally, we believe that liquidity risk might be reduced in markets that encourage diversity of participants. The paradox? More diversity might well mean less regulation rather than responding to current calls for more.
1. Bank of England, “Financial Stability Report”, Issue Number 21, Bank of England (April 2007) – see especially page 18, Box 2, “Financial Market Liquidity”.
2. JANEWAY, William H, “Risk versus Uncertainty: Frank Knight’s ‘Brute’ Facts of Economic Life”, Social Science Research Council (19 October 2005).
3. Stephen Martin and Michael Mainelli, "Why Bother to Be Better? Strategically Stagnant Personal Current Accounts", Journal of Strategic Change, Volume 12, Number 4, pages 209-221, John Wiley & Sons (June-July 2003).
4. Michael Mainelli, "Assessing Credit Rating Agencies: Quis Aestimat Ipsos Aestimatores?", Balance Sheet, The Michael Mainelli Column, Volume 11, Number 3, pages 55-58, MCB University Press (August 2003).
5. O’HARA, Maureen, “Liquidity and Financial Market Stability”, National Bank of Belgium Working Paper Number 55 (May 2004).
6. Jan-Peter Onstwedder and Michael Mainelli, "Enter the Specialists" (credit derivative market transformation), Risk Professional, Issue 2/10, pages 32-35, Informa Group plc (December 2000/January 2001).
7. PERSAUD, Avinash D, Liquidity Black Holes: Understanding, Quantifying and Managing Financial Liquidity Risk, Incisive RWG Ltd, 2003.
For their many discussions which helped to shape this article, and with no assumption of responsibility for the result, I would like to thank Avi Persaud, Brandon Davies, Jan-Peter Onstwedder and Andrew Hilton. I would also like to thank Gresham College for allowing me to develop my thoughts, partially expressed in this lecture ....
Gresham College – "Liquidity: Finance in Motion or Evaporation?" – London, England (5 September 2007).
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