Decoding Financial Liquidity

Note: This is the first of a three parts series titled, “Understanding Liquidity”

A liquid is a unique and multifaceted natural substance. It cannot be compressed, and it conforms to the shape of its container while retaining a nearly constant volume independent of pressure. A liquid is one of four fundamental states of matter, but it is the only state that has a definite volume and no fixed shape. Unlike a gas, a liquid does not disperse to fill the available space and maintains a nearly constant density. Liquids flow, and that flow can be either smooth and easily calculated or turbulent, complex and chaotic — a continuing challenge to hydrodynamics, the study of liquids in motion.

The financial concept of liquidity as described by Shleifer & Robert employs some of the physical characteristics of liquids, at least metaphorically. At its best, market or financial liquidity is a state in which funds freely flow and securities are easily bought and sold. That’s the simplest definition of liquidity. But, like liquids, market liquidity is complex, multifaceted and nuanced. If we are to understand and quantify its many aspects, we must examine its components and tendencies more closely.

Financial liquidity is believed to be extremely important to the health of a financial entity. In the economic literature, liquidity refers to the ability of economic agents to exchange their existing wealth for goods and services or other assets. Liquidity is considered in terms of flows and refers to the ability to realize these flows. Failure to do so renders the financial asset illiquid — that is, unsellable; an asset that cannot be sold cannot be valued. Liquidity is often limited, creating various degrees of illiquidity, because of information asymmetries and incomplete markets.

A sudden liquidity shock in even a single market segment or individual instrument can cause damaging disruptions throughout interconnected global financial markets. In August 2007, for example, African markets began to reflect tensions as money market liquidity plunged after credit rationing hit interbank lending markets. Banks refused to lend to one another because of uncertainties over their exposures to structured products; because no one knew the amount of that exposure, the liquidity of structured assets dried up, making it difficult to value them. Central banks were forced to inject liquidity into the markets.

In practice, financial market liquidity is nuanced and can fulfill a variety of functions: central bank liquidity, funding liquidity, market liquidity, interbank liquidity and asset-market liquidity. Central bank liquidity refers to the ability of a lender of last resort to supply liquidity needed by the financial system — a flow of the monetary base from a central bank to the financial system. This operations liquidity — the amount of liquidity provided through central bank auctions to money markets — depends on the bank’s monetary policy stance. For instance, the recent Kenya’s central bank policy known as quantitative easing is a powerful mechanism to inject liquidity into the financial system. Under QE, the central bank commits to buying a large number of targeted securities and thus reduces liquidity premiums (the additional yield on an investment that cannot be readily sold at its fair market value) and trading frictions. Quantitative tightening is the reverse of QE and involves selling securities with the aim of normalizing interest rates, which usually means raising them.

The Basel Committee on Banking Supervision defines funding liquidity as “an entity’s capacity to finance increases in its volume of assets and to comply with its payment obligations on maturity, without incurring unacceptable losses.” In this regard, liquidity risk is the probability of incurring losses because there are insufficient liquid resources to meet payment obligations within a set period of time, taking into account the ability to sell assets in a reasonable time and at certain prices. From the point of view of traders or investors, funding liquidity means their ability to raise capital or cash on short notice. Because funding liquidity is a flow concept, it can be interpreted as if it were a budget constraint: An entity is liquid as long as inflows are larger or at least equal to outflows. This holds true for firms, banks, investors and traders.

According to John Maynard Keynes research titled “A Treatise on Money in 1930,” he defines market liquidity as the ability to trade an asset on short notice, at low cost and with little impact on price. This implies that market liquidity depends on several variables, the most fundamental of which is the ability to trade. Market liquidity incorporates key elements of volume, time and transaction costs.

Liquid markets offer many benefits, including improved allocation and information efficiency. Liquidity fosters a stable monetary transmission mechanism and more efficient crisis management. And liquidity makes financial assets more attractive for risk-averse investors, who can buy and sell them more easily.