IS the fragility of market liquidity a reason for concern? The ‘flash rally’ in US Treasury bonds in October 2014 and the German Bund tantrum’ in April 2015 show that dislocations can occur even in markets for highly liquid assets. A rise in US interest rates might cause more disruption. Some add that new regulations constrain the ability of banks to act as market makers and so reduce the liquidity of markets in riskier assets.

How far should we share these concerns? Market liquidity is likely to disappear when one needs it most. Building our hopes on its durability is risky.

This is far from the conventional wisdom. Indeed, chapter two of the International Monetary Fund’s new Global Financial Stability Report offers a paean to liquidity’s virtues: market liquidity — the ability to execute sizeable securities transactions rapidly, at low cost and with limited impact on prices — is important for financial stability and real economic activity. So is the resilience of market liquidity. Lower liquidity, it warns, reduces the efficiency of financial intermediation and might inhibit growth. Low market liquidity, it adds, might vanish in response to shocks. .

We need to start with the relationship between market, funding and monetary liquidity. Funding liquidity refers to the ability to borrow easily. Monetary liquidity is a measure of the ease of monetary conditions. These three concepts are distinct, but related. Funding liquidity facilitates market-making. Monetary expansion eases funding for banks. Thus funding and monetary liquidity promote market liquidity.

Such links are why tightening of monetary conditions might affect market liquidity. Mutual funds, for example, hold large quantities of emerging market dollar-denominated corporate bonds. Suppose investors wanted to redeem their holdings in response to growing concern about the solvency of these borrowers. This might create an avalanche of sales and huge falls in prices, triggering margin calls, yet more sales and worries about the solvency of additional counterparties.

If liquidity is a fickle friend, should we hanker after it at all?

It is in such circumstances that the two-way trade that is the basis of market liquidity might disappear. Market liquidity is a fickle friend. In times of high stress, central banks might even be forced to become market makers of last resort. This is indeed part of their job in the markets for their government’s bonds. But should they provide those services in the markets for other assets, too?

The IMF’s conclusions are ambiguous. First, it argues, liquidity indicators are strong for investment-grade bonds, less so for high-yield and emerging market bonds. Second, benign cyclical conditions are masking liquidity risks. But these might (and probably will) change quickly. Third, regulatory changes have had a mixed effect, though the IMF recognises that market-making by banks has been made more difficult. Fourth, the rising role of asset managers, pension funds and insurance companies in intermediation are sources of less resilient liquidity. Finally, easy monetary policy has increased market liquidity but raised liquidity risk — since, at some point, this flood of money will reverse.

The big problem with such analyses of market liquidity is that things tend to look fine until they do not. One has to focus instead on the tail risks. For this reason, complaints about the impact of bank regulation should be ignored. The difficulty with the complaint is that in the run up to the global financial crisis, few worried about a possible disappearance of market liquidity. But it vanished when most needed, even though none of those onerous regulations then existed.

Thus, the absence of regulation exacerbated the liquidity boom and subsequent bust. If relaxed regulatory requirements encourage banks to provide liquidity in good times, only to run away when unable to fund themselves, we end up in the worst of all worlds. Overconfidence in fair-weather liquidity should be discouraged. Investors ought to worry, instead, since the risk that nobody will be on the other side of their trades is a real one.

We should contest the conventional wisdom on the benefits of market liquidity propounded by the IMF. The world economy should not be based on confidence in something likely to vanish. It would be better if investors appreciated the risks of a freeze in market liquidity in riskier financial assets.

Furthermore, markets in which a huge proportion of participants buy not to hold, but in the hope that they can jump off profitable bandwagons in time, are likely to be both unstable and unproductive. The question, at its most basic, here is whether the shibboleth of market liquidity is consistent with the need for markets to have informed and committed investors.

If liquidity is such a fickle friend, should we hanker after it at all? Would it not be better if investors understood that the assets they own might not be liquid in all circumstances and made investment decisions on that assumption? I would suggest that markets characterised more by longer-term commitments, and less by hopes of finding ‘greater fools’ willing to buy at all times, might be better for most of us. This will not be true for all assets — notably government bonds. But it will be true for many private instruments.

Particularly given the current role of mutual funds subject to redemption on demand, policymakers must plan for the next panic. But keeping markets liquid when panic comes risks making the next crisis worse. We have become addicted to market liquidity. But it is too fragile and perverse in its effects on incentives to be viewed as a universal feature of our capital markets.

martin.wolf@ft.com

Published in Dawn, Business & Finance weekly, October 12th, 2015

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