Matthew Spiegel, finance professor at Yale School of Management likens financial institutions’ view of liquidity to manufacturers’ view of inventory: the most liquid or easiest to move inventories are the easiest to manage. Now, as financial institutions move into the new Dodd-Frank world, they are more incentivized than ever to manage liquid inventories of financial products.
For financial intermediaries, the challenge is managing inventory with the least risk exposure. The financial industry and its regulators are continually seeking ways to ensure that the market remains liquid while minimizing the amount of risk introduced. From regulators perspective, improving the availability of data and trading information is one way to optimize liquidity and reduce risk exposure.
However, it’s not always easy to simply optimize liquidity and cut exposures. Not all financial instruments can be moved in a short period of time, thus using speed and price impact as the defining categories of liquidity doesn’t capture the whole picture. In some situations, having more time to wait for the right counterparty for a product can lessen the price impact significantly enough that in the end, holding on to a product for a longer period of time can actually improve liquidity.
Spiegel notes that in isolation, asymmetrical information equates to less liquidity than symmetrical information. Still, there are a number of factors that impact into liquidity beyond symmetry of data. These factors can include size of market, credit rating, or hedging opportunities to name a few. Looking at symmetry alone, corporate bonds are more symmetrical in structure than stocks because they offer a fixed return. Yet, stocks are much more liquid than corporate bonds. In order to understand this, one has to take into account the market forces at play. The amount of stock a company has outstanding, for example, will always outweigh the size of a particular corporate bond issuance, and stocks also present many hedging opportunities. In the end, these other factors tip the equation in favor ofmoreliquidityforstocksdespitebonds’structuralsymmetry.
Consider the differences between large and small cap stocks since the financial crisis. Financial markets principles would suggest that less price slippage equates to more liquidity. For large cap stocks, price slippage has reduced dramatically since 2008, indicating that the market has become much more liquid. But for small cap stocks, slippage has actually increased. The trend in small cap stocks seems to contradict most expectations of market performance, but the explanation for the trend may be the result of an asymmetry in data.
For large cap stocks, there is a lot of trade activity and a lot of trade data, resulting in a market that is very transparent for investors, and very liquid. For small cap stocks, information is not as easily accessible, and the asymmetry of available information negatively impacts market liquidity. A number of potential hedging opportunities arise when there is an asymmetry of information as we see in the small cap market. These activities are not without their own risks, but they may also lead to greater liquidity within small markets as interest in those markets increases.
In a recent paper entitled, “Liquidity and Portfolio Choice: A New Approach,” Mark Kritzman, president and CEO of Windham Capital Management, alongside Will Kinlaw and David Turkington, managing directors at State Street Associates, propose a new way of accounting for liquidity. They treat liquidity as a “shadow allocation.” Essentially, in this model, liquidity becomes a financial product itself – increasing or decreasing in value similar to other assets. If investors deploy liquidity to raise a portfolio’s expected utility, they attach utility as a shadow asset to a tradable asset. If liquidity is deployed to prevent a portfolio’s expected utility from decreasing, then liquidity is considered a shadow liability to a non-tradable asset.
The authors argue that this maps liquidity onto expected risk and return such that investors can analyze liquidity in the same context as other portfolio decisions. Liquidity not only meets demand for capital, but it lets investors exploit opportunities. The authors add that treating liquidity as a “shadow asset” more clearly demonstrates that investors bear an illiquidity cost to the extent that any por tion of a por tfolio is immobile.
These differences in how liquidity is represented, driven by information, size, and interest, are overarching themes for almost all types of financial products. Participants can use these factors to make trading decisions on equities, the OTC markets, or across virtually any asset class. Regulators too, monitoring systemic risk will do well to understand how each of these macro themes can impact how they assess overall risk in the market. Skilled investment managers rely on these broad themes to develop trading programs, the next step will be for regulators to better understand the fluidity of these decisions and provide guidance on market structure, accordingly.
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1. Spiegel, Michael, “Patterns in cross market liquidity,” Financial Research Letters Volume 5, Issue 1, March 2008, Pages 2–10
2. New York Fed, “Financial Stability Monitoring,” June 2014 http://www.newyorkfed .org/research/staff_reports/sr601.pdf
3. Mark Kritzman, Will Kinlaw, David Turkington, “Liquidity and Portfolio Choice: A New Approach,” The Journal of Portfolio Management, Volume 39, Number 2; Winter 2013