The expression liquidity has acquired another meaning, when referring to instruments which trade actively or have narrow bid-offer quotations. Larger government bond issues are more ‘liquid’ as their size increases, which results in lower issuance costs and narrower bid-offer spreads. This latter phenomenon is, in large part, a result of the ease with which they may be borrowed to facilitate dealer short sales. It is perhaps perverse that increasing supply should lower the price but this phenomenon is exhibited by many speculative strategies. Price rises may often induce further purchases under such strategies.
The interest rate swap market is amongst the most active by number of transactions and notional values traded; but, by design there is no exchange of liquidity at contract inception. Mark-to-market calls for collateral and liquidity under credit support agreements can be substantial and untimely, as many pension funds have found to their cost. These are the very antithesis of a liquid instrument; a liquidity liability. This is a challenge for regulators requiring the use of swap rates as discount functions in valuation.
Many institutions have been constructed to overcome the liquidity limitations of an individual life-time. In early adulthood, with the advent of children, most families have substantial needs and may credibly pledge future income. In retirement, with no occupational income, the elderly may not. These are inter-generational institutions, which surmount the life-styling of saving and investment.
The security of these institutions concerns both the individual and the state. This has led to the current generation of balance sheet solvency or capital adequacy regulation. However, there is an important distinction to be made between equitable insolvency and this regulatory balance sheet insolvency – and, most interesting, it is evident in corporate bond markets. These operate, absent covenants to the contrary, on the basis of equitable insolvency; the obligor must default and fail to cure that within some agreed period, before the creditor may act to ensure performance. It is common, but by no means universal, for default to accelerate the term of the loan, making it immediately repayable. Balance sheet insolvency requires no such liquidity shortage. Under current accounting and regulatory standards this occurs when the present value of liabilities is greater than the current value of assets measured at market prices under fair value standards, current liquidity.
An institution may be illiquid but solvent, this is usually trivially cured; even payment in kind is possible. In general, equitable insolvency occurs after balance sheet insolvency and in consequence the rates charged by creditors on marketable debt instruments are lower than might be the case under balance sheet insolvency. Many of the protective covenant security mechanisms of debt instruments serve to shorten the term by introducing a financial statement insolvency event, occurring prior to balance sheet insolvency, and have the effect of increasing the likelihood of its occurrence. The priority of a claim in liquidation, and the time to that claim-holder group insolvency are related.
This is not the only instance where security-taking induces perverse effects. Consider an institution which has an obligation to pay a perpetual annuity of €10 and current cash assets of €100. It is solvent if the discount rate is 10% or higher. It is insolvent if the discount rate is lower than 10%, though the fundamental position, that it has adequate funds to pay for 10 years of annuities, is unchanged. After the payment of the current year’s annuity it needs €10 to remain solvent and the same again the year after, and so on. The annuity has reduced to a pay-as-you-go arrangement and begs the question: what is the purpose of the funding buffer if not to permit time to cure insolvency and illiquidity.
For a solvent institution, the discount rate is a simple determinant of the time from balance sheet to equitable insolvency in the absence of future income and lower rates imply longer terms. It is far from obvious why it is desirable or effective from a security standpoint, the regulatory objective, to vary the level of liquidity coverage of liabilities in this market discount rate determined way.
Similar questions of liquidity arise over the use of market prices to value assets. When the source of expected liquidity is specific rather than market-based, and the term of holding long, the degree of dependence of the investment institution upon market-based liquidity is slight. Immature institutions may be suppliers of liquidity to the market rather than reliant upon it.
Listed equity markets are no longer a material source of capital for corporate investment; for major companies, they have been supplanted by debt capital markets. Only the purchase of new shares or bonds constitutes new investment in the real economy. Disclosure of the intended use for funds being raised was once standard. It is new investment which drives growth in production as new technologies are introduced. Though many analysts are pre-occupied by economic growth and attribute market performance to this, any relation is tenuous and empirically absent.
Today, the dominant aspect of markets is the game against others rather than the game against nature. In this world speculation dominates, volatility abounds and prices may prove far from efficient mechanisms for resource allocation. And the medium of that resource is liquidity. By way of ending, the time-honoured advice is: “In all of your analysis, follow the cash”.
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