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Which liquidity worries you?

29 January 2016
Richard Kemmish


In my previous post I discussed the relative insouciance of covered bond investors towards bank credit – only a problem for 20% of them. The other surprising result from the same question in the Fitch survey was that 75% of investors think that liquidity is a problem. 

I would like to propose that we ban the word ‘liquidity’.  Why? Because it seems to mean such different things to different people. For me there are at least four different meanings to the word.

Meaning one, the man-on-the-street meaning of liquidity, is turn over. How many bonds are actually traded on an average day? Or if the man on the street is particularly insightful, how many bond are actually traded on a day with significant market stress? That is easy to quantify, easy to understand and, of course, easy to manipulate. Even without manipulation it is very poorly correlated to the second meaning.

Buy side liquidity. Can I, as an investor, buy the bonds that I want to buy, preferably in a meaningful size and preferably without moving the market against me?  I suspect that this is the average investor’s definition of liquidity when they fill in Fitch surveys with a heavy sense of grievance about the unfairness of the market. This definition is correlated to the first definition, but the correlation is weak, particularly in a stressed market.

What should be more important is sell side liquidity. Can I exit this position? For me there are two elements of this, can I exit the position in normal market conditions at a price approximating to the level that I currently have it marked at? Underlying this is the same concern as is underlying buy-side liquidity (and therefore presumably the same level of grievance): fund manager p&l. The second part of sell side liquidity is where it gets systemically important: can I sell in a stress scenario? It is also where it differs from buy-side liquidity – no-one ever went bust because they couldn’t buy a bond.
 
Which leads to the fourth type of liquidity: regulatory liquidity, the liquidity that underpins bank LCR buffers.  It is correlated to sell side liquidity, but not identical. In particular sell-side liquidity is about a systemic stress, everyone trying to sell their bonds at the same time (this is, I believe a significantly underestimated risk in the markets in general as the level of biodiversity in investor land falls: the behaviour of ETFs are strongly correlated, the behaviour of hedge funds aren't).

Regulatory liquidity on the other hand is idiosyncratic – can I fire-sell enough assets to protect my own liquidity in an otherwise calm market? (of course an idiosyncratic stress can trigger a systemic stress in the markets, but it is not necessarily the case as many recent, isolated, bank failures have shown). Also, regulatory liquidity can be non-market based, in which case central bank emergency repo rules become just as important as the existence of willing buyers.

Which liquidity are 80% of investors really concerned about?

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