Dr Con Keating on ”The long and the short of liquidity”

The price of an asset is tautologically its liquidity, its “moneyness”. An asset may also possess other, usually lower, liquidity values – for example, those arising from its use as collateral security for advances. In recent times the increased use of secured borrowing in the banking system has been remarkable; this is financing of assets held.

It is important to realise that value and liquidity are not synonymous. It is not only perfectly possible for the value of an asset, to its owner, to exceed its price; it is most often the case. Behavioural psychologists consistently report that the owners of assets require substantial premiums to part even with apparently mundane property such as coffee mugs.

Credit is an expectation of future liquidity. An advance made is expected to be repaid by the debtor according to some future time schedule. It is well-defined and specific to that obligor. The terms may be enforced and collection assured by process of law.

The practice has developed of relying upon financial markets for future liquidity; a security may be bought with an associated expectation of future sale. This future sale price is unknown and, some might argue, unknowable.

This difference in the source of future liquidity may be used to define investment and speculation, and the distinction between them. Examples of investment might range from a government bill subscribed and held to maturity to equity held solely for the collection of dividends. This resonates with the use of the expression ‘investment’ by entrepreneurs and capitalists. The returns depend only upon performance of the contract. By contrast, speculation relies upon sale at a market price for its returns. The trading of securities at the frequency of a few microseconds, where there are no interim cash-flows, is pure speculation.

These illustrations are polar extremes and there is a continuum between them. This is directly related to the length of time over which the security is held. Even a bond held to maturity (and the non-market source of that liquidity) has a speculative element to it if the interim coupons paid are reinvested through market price mechanisms. Similarly, an equity held for long periods may have accumulated appreciable dividends relative to its market price, and with that, higher investment characteristics.

In this view, much of modern financial theory is better described as a theory of speculation rather than investment, and notably was in Louis Bachelier’s seminal 1900 thesis: “Theorie de la Speculation”. Certainly the replication, “hedging” strategies of the Black-Scholes-Merton option pricing model may be categorised in this speculative manner. Indeed hedging against adverse price development in an asset is generically speculation.

The counterpart to both investment and speculation is saving, consumption deferred. For the individual this can be motivated in several ways. There are terms associated with these motivations. Bequests for our children and successors have the term of our life-span, retirement savings the term beyond which we expect to be occupationally employed, or simply for our next birthday party. Savings may also have undefined term such as ‘until we have enough to buy that Mercedes’, or even be entirely precautionary in nature – provision for the rainy day. Indeed, even the money in our pocket is a form of precautionary saving. It is our primary risk management tool.  It facilitates exchange by removing uncertainty, and admits the exploitation of specialisation in production and gains from trade.

These precautionary motivations are probabilistic in nature – we may never become ill, or unemployed, or suffer a flood or fire. One of the few things we know with certainty about risk is that more things may happen than will happen. A consequence of this is that institutions can be devised which exploit this property. The bank may undertake maturity transformation by making long-term advances financed by precautionary demand and short-term deposits. The insurance company may pool risks and offer cross-subsidy, lowering the savings costs of indemnifying the unfortunate. This is socially valuable finance.

The demand for investment capital from the private, industrial and commercial sector and the public authorities may differ in term and amount markedly from that desired by individual savers. Indeed many individuals may wish to increase their current consumption at the expense of future. Though unlimited in principle, the creation of such credit is limited by the stock of current wealth and that which may be created within the term of the advance. As recently as the 1970s it was not unusual for loans and bonds to be created which were amortising or self-liquidating – the project was expected to generate the cash-flow liquidity to service and repay the debt over its term. Indeed, in the 1920s, much government debt, particularly that issued internationally, had “earmarked” revenue streams, such as particular customs duties, to support it.

This elementary view has been supplemented by the notion of ‘confidence’. Here, the belief is that the debtor may at some future time refinance the debt to meet its current obligations. This is a form of speculation or reliance upon markets. The assumption is that at this future date, even more remote production and wealth may be capitalised.

It is possible to think of perfect liquidity in these terms. Here the finance director may capitalise all future revenues at the ‘risk-free’ discount rate. This rate has been the subject of much discussion in recent times as it was commonly proxied by government bond yields. It is subject to the technical condition that it should be a zero-coupon or discount rate, since the absence of interim cash-flows ensures that the arithmetic and geometric mean returns are congruent. It is simply a pure liquidity preference rate. Savers will accept a low rate only if future liquidity is expected to be high. When there is doubt as to the future ability and willingness of a debtor to repay, higher rates will be demanded. This liquidity preference rate is the cost of liquidity – and liquidity must have a cost, even in this perfect world, since if it did not all assets would be perfectly liquid.

This nirvana of perfect liquidity does not exist for many reasons – natural uncertainty is just one. Many future revenues may not be pledgeable. The separation of management from ownership in modern shareholder companies and the associated principal-agent problems is another. These frictions and costs may even be unobservable in the sense of future revenues foregone through management ‘shirking’. One possible interpretation of much of the academic ‘myopia’ literature which finds that future income and gains are discounted at very high rates is precisely that these future revenues are underestimated or disregarded by markets – in a sense, were unpledgeable.

Most corporate finance directors will concur in preferring to make a sequence of future payments in time rather than to provide their present capital equivalent today. In part this may be because their cost of production of those future cash-flows may be better than that implied by the discount function and in part because market liquidity imperfections mean that capital is not available to them on equivalent terms.

One corporate management response is to hoard liquidity; to maintain demand deposits, hold government bills, or negotiate lines of credit. These are frequently short-term instruments and high quality instruments. These are not subject to material market price uncertainty over the term to their maturity, nor to substantial default likelihood. They are information-insensitive instruments. These instruments share the feature that their value as collateral is very close to their value in market sale – the haircuts applied in ‘repo’ are typically small. They are usually also eligible for discount or repo with the central bank or monetary authority.

The absence of liquidity from the pantheon of banking regulation prior to the crisis was theoretically justified by the fact that the central bank was the ultimate insurer of liquidity for the banking system as lender of last resort to solvent institutions.

It is unfortunate that common usage has added another meaning for the expression liquidity, when referring to instruments which trade actively or have narrow bid-offer quotations. The practice developed of considering larger government bond issues more liquid as their size increased, which resulted in lower issuance costs and narrower bid-offer spreads than might otherwise have prevailed. This latter phenomenon is, in large part, a result of the ease with which they may be borrowed to facilitate short sales by dealers.  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. The subsequent mark-to-market calls for collateral and liquidity under credit support agreements during their term can be substantial and untimely, as many pension funds have found to their cost. These are the very antithesis of a liquid instrument. They are a liquidity liability. There is a challenge here for those regulators who would require 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 is properly a matter of concern for 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, in the absence of covenants to the contrary, on the basis of equitable insolvency; the obligor must default on a payment (of liquidity) and fail to cure that default within some agreed period, before the creditor may act to ensure performance. It is common, but by no means universal, for an act of 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 form of insolvency 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. It is, of course, debatable whether substantial institutions could actually realise all of their assets at these prices, but that is a moot point, provided the institution is current in its obligations.

Though it is possible for an institution to be illiquid but solvent, this is usually trivially cured and even payment in kind is possible. The result is that, in general, equitable insolvency occurs after balance sheet insolvency and a consequence of this is that the rates charged by creditors on 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. There is an equivalence between the priority of a claim in liquidation and the time to that claim-holder group insolvency. This is far from the only instance where the taking of security 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 ten 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 may be slight. Immature institutions may be suppliers of liquidity to the market rather than reliant in any way upon it.

Listed equity markets are no longer a material source of capital for corporate investment. To a large extent, they have been surplanted by debt capital markets for major companies. Only the purchase of new shares or bonds constitutes new investment in the real economy. Not so long ago, it was standard to be told the intended use for funds being raised. It is this 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, I’ll repeat advice I received long ago: “In all of your analysis, follow the cash”. To this I will add a caution: in recent decades, financial development and innovation have not been much concerned with increasing our wealth, but rather more with devising ever more claims of ever-increasing complexity on that wealth. “Timeo Danaos …” is the time-honoured counsel.

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