Sunday, October 25, 2015

Measuring market liquidity - asking for buckets is not a solution to the problem


The SEC is proposing new rules on mutual fund and ETF liquidity. Last year there were instituted new rules on liquidity for money market funds. Fund managers will have to measure or bucket all assets based on their relative liquidity. The Fed has focused a significant amount of research on determining the level of liquidity in the Treasury and corporate bond markets over the last year. ECB president Draghi and many of the biggest players in the bond market have all commented on current liquidity issues in fixed income. The underlying feeling by market practitioners is that liquidity across all major asset classes is not as deep as before the Financial Crisis regardless of the research. Liquidity events in the form of flash crashes seem to have hit every major asset class. The number two risk issue from the Credit Suisse 2015 hedge fund investor survey was market liquidity.  Nevertheless,  we do to have many readily available measures of market liquidity.

Measures of bid-ask spread, volume, or average trade size are helpful in providing information on liquidity but does not tell us whether liquidity will be available upon demand. The liquidity definition, "we know it when we see it", is not helpful in measuring the real problem. Showing specific situations of low liquidity is interesting and important but plays into the "law of small numbers" bias, extrapolating from a few examples. Still, the old adage that you never have liquidity when  you need it still apples.

A set of rules that require measures of liquidity based on time limits needed for liquidation may not get at the real issue. The basis for measuring liquidity is still not clear and asking for buckets is not a solution. Two managers may not agree on the amount of time necessary to liquidate without market impact the same sized position. Asking for portfolio buckets of this liquidity may only give regulators and investors a false sense that liquidity is measurable. A false hope that liquidity can be effectively measured may only increase risk in a crisis. 

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