Friday, November 21, 2014

The Coming Liquidity Implosion

A couple times per year I dust off a quote I first used on these pages during August 2007's quant quake:

Liquidity in Business and Markets
'Liquidity is expensive but illiquidity is much more so, because it destroys the very existence of a firm"
I don't remember if it was Johannes or Ernst, it was a long time ago that I read Manchester, quoting one of the Schroeder boys on the insolvency of Krupp. That line has stuck with me. Here's the book.
And here's FT Alphaville
The liquidity monster that awaits
Fears are growing that the next crisis, if it should manifest, won’t come from any of the areas that spawned the 2008 crisis. To the contrary, it will emerge from areas we’ve not really had to worry about to date.
The key areas those in high places are now worrying about: the taken-for-granted presumed liquidity of the system.

This is an easy assumption for the asset management industry to make. For years investment banks have made a business of carrying liquidity risk on their balance sheets, mainly by internalising the inventory nobody else is prepared to hold. This sort of “we’ll buying anything just to make money from making markets” service as a result conditioned the buy-side to presume liquidity risk is something that just doesn’t really manifest anymore.

As a consequence, liquidity — especially in the major asset classes like Treasury bonds and blue-chip stocks — is often taken for granted by the industry....

That 2007 post contained another interesting bit:
Alexander Campbell at Risk: Over the Counter brings us a timely paper:
According to this (fortuitously topical) paper, liquidity is hugely valuable: "a liquid asset can be worth up to 25% more than an illiquid asset, even though both have identical cash flow dynamics". Or, to put it another way, a sudden absence of liquidity could in effect mean a 20% drop in portfolio value, even if the assets - and their market prices - remain constant. Nasty.
For more on the quantpocalypse here's MIT's uberquant Andrew Lo via the New York Fed:

"What happened to the quants in August 2007? Evidence from factors and transactions data∗"
(77 page PDF)

If you want to take the other side, you can do a bit of intertemporal arbitrage and own the Warren Buffett holding period: "forever" or at least the old insurance investment line, "The only quarter to worry about is the next quarter-century":
Riding the Liquidity Premium: Liquidity As An Investment Style