Actuaries are encountering liquidity more often, whether it is to do with essence, risk, institutions, markets or regulation, say Con Keating and James Walton
'Liquidity' is a confusing topic with many interpretations. Actuaries are encountering the concept in a number of contexts:
? Investment practitioners increasingly operate in a world where liquidity appears deceptively deep but evaporates overnight
? New regulation in both insurance and banking is generally requiring more liquid assets to be held
? Long-term investors in both life and pensions are increasingly searching for additional yield in less liquid asset classes
? Credit risk capital under Solvency II can be affected by identification of an 'illiquidity premium', through the matching adjustment.
In order to understand these different, but related themes, we go back to basics and consider the definition of liquidity, the meaning of a liquid market, and how current market and regulatory conditions may affect institutional investment strategy.
Here we focus on market liquidity and do not describe in detail other aspects of liquidity management from the firm's perspective, such as retaining dividends or utilising borrowing facilities.
What is liquidity?
Liquidity, as an asset class characteristic, is the degree of inter-exchangeability of money and the asset. In other words, having sufficient liquidity is about having sufficient access to money. There are three main types of money: currency, bank deposits and central bank reserves.
Liquidity has a cost
Investors want liquidity as they value the option of liquidating an asset for money. With deliberately provocative language, we might say that liquidity affords investors the luxury of a lack of commitment to their investments. It provides investors the opportunity to participate in markets without incurring the costs of research and information discovery. The purchase of this embedded liquidity option has a cost to the holder, through a higher purchase price or lower yields.
In practice, it is convenient to compare prices of less liquid assets to the most liquid, low-risk asset (usually government bonds), as the market price of these low-risk assets are readily observable. It is common to then attempt to decompose the price or spread difference into compensation for credit risk and 'illiquidity premia'. Looking through this lens only - particularly when the 'illiquidity premia' is a balancing item in this analysis - can often obscure the mechanism that liquid asset prices are being driven, in part, by the price of liquidity itself. This is a different dynamic to the 'illiquidity premia' being a necessary compensation for the risks and costs of investing in an illiquid asset.
A market context
Assets are liquid only to the extent that markets in them are liquid. Liquidity in a market may be measured by:
? Market 'depth', or the ability to execute large transactions without influencing
? 'Tightness', or the gap between bid and offer prices
? 'Immediacy' or the speed with which transactions can be executed
? 'Resilience', or the speed with which underlying prices are restored after a disturbance.
Information asymmetries in markets between buyers and sellers - for example, in the market for secondhand cars or for mortgage-backed securities in 2008 - generally give rise to declining trade with price clearing at the lowest quality asset. Conventions and common knowledge among market participants improve the liquidity of markets.
Market liquidity is improved when there is active trading that can be facilitated by market markers. The withdrawal of market makers means liquidity is deceptively shallow in credit markets. USD stock in trading books has fallen at least five-fold, since pre-2007.
Larger issue sizes are more liquid, both in terms of the volume of stock that can be traded and in terms of the fact that active trading is concentrated in a small number of the largest issues. This effect is getting more extreme as Figure 1 (below) demonstrates.
This decline in liquidity has not just been confined to credit. We have seen the Treasury 'Flash Crash', and equity volatility in August 2015 seems to have been far in excess of that justified by fundamentals.
Are liquid markets beneficial?
The benefit to society from liquid markets comes through the facilitation of outside trade, that is, outside the financial system, not necessarily from increased activity among insiders. A market can be highly liquid, as measured by velocity of circulation, without this necessarily giving rise to the benefits of outside trade.
For example, the FX market in USD is extremely liquid as measured by turnover, with $4.5trn in 2013. The stock of USD, defined as liabilities held by the USD banking system, is a similar figure. Very few of these FX transactions are driven by consideration of real trade or capital flows; rather, it is trade between insiders of the banking system. There is a similar situation with high frequency trading, which has enhanced inside flows in many markets in recent years.
While some short-term market activity may facilitate the execution of real economy enhancing outside exchange, excessive volumes of short-term activity can even be to the detriment of the outside welfare.
Considerations for actuaries
While a pension scheme or insurer may be comfortable and have excess liquidity in terms of withstanding shocks and meeting liabilities, all other motivations for asset sales should be considered when evaluating the economic value they should place on the liquidity options inherent in their asset strategy.
The value institutions place on this liquidity option should reflect the additional compensation they require when reducing the liquidity of their investment strategies, which institutions are increasingly doing to enhance yield. At an extreme, a theoretical 'buy-and-hold' investor would expect to lose money, relatively speaking, if they bought liquidity options that they never intended to exercise.
Any assessment should include:
? Increased capital required against an illiquid asset that is downgraded and
cannot be sold
? Opportunity cost of holding fewer liquid assets to take advantage of future market dislocations and regulatory changes
? Costs incurred upon asset sales for any other reason.
In evaluating the likelihood of forced sales in the future, institutions may examine the extent to which asset cashflows match liability cashflows.
Policy and regulation
Given the cost of holding liquidity, it is to be expected that, left to their own devices, financial institutions will tend to minimise their holdings of liquidity stores and under-provide for contingent events where significant excess liquidity is required.
The response to the crisis has included direct regulation relating to the liquidity of institutions, as well as many other areas that may affect liquidity in the financial system.
Incentives have been created to generally hold low-credit-risk assets. Central clearing requirements have placed additional liquidity requirements on institutions.
The effects of liquidity regulation are still developing, but most appear to be detrimental. Minimum liquidity requirements at the institutional level do not necessarily improve liquidity in the system or mitigate the impact of liquidity shocks alone. Fundamentally, as economist John Maynard Keynes said nearly 80 years ago: "There is no such thing as liquidity of investment for the community as a whole."
In summary, the crisis, and the response to it, have brought shifts in the liquidity of markets and management within institutions. More is not always better; so-called liquid markets may not remain so and are not necessarily beneficial to the wider economy. Holding liquid assets has a cost that is often not recognised.
In addition to the impact of liquidity on capital calculations, actuaries are well placed to understand and communicate the themes in this article so that our clients have an appropriate investment strategy and liquidity management framework. This can improve outcomes for the financial system and, for example, by giving institutions the confidence to invest in long-term projects, provide a real economic and social benefit.
Perhaps in doing so, 'liquidity' can even become a less confused topic.
The authors wish to thank Jon Hatchet, Andrew Smith and Tony Zhao of the IFoA Liquidity Working Party. This article is based on the IFoA Sessional Research paper, Liquidity: Essence, Risk, Institutions, Markets and Regulation (bit.ly/1R9G7Ck).