Friday, December 23, 2011

Liquidity and Asymmetric Information

I've been reading a bit on the financial crises recently. One paper by John Taylor, here, describes an endeavor to decipher whether frozen credit markets were a result of liquidity risk or counterparty risk. The discussion of liquidity risk brought up an old nuisance of mine -- the meaning of liquidity across the various contexts in which it is used.

The term liquidity is thrown around in the financial press quite often. Some common examples heard often:

  • The fed is adding significant liquidity to the market 
  • There's a significant liquidity premium for those assets 
  • Banks are facing a liquidity crisis 

I've thought quite a bit about what the term liquidity actually means, and wanted to share my conclusions to date.

First, a few preliminary matters:

Investopedia defines liquidity as "The degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is characterized by high levels or trading activity. Assets that can be easily bought or sold, are known as liquid assets."

Multiple types of liquidity exist. The definition above is used in the context of market liquidity. Another liquidity, funding liquidity, refers to a company's ability to meet obligations as they become due.

These separate meanings offer the first insights into why some confusion exists (at least on my part) when liquidity is used in economic discussions.

Both of the definitions above appear to be static characteristics of assets (market liquidity) and companies (funding liquidity), at least in the short term. Given these definitions, certain questions remain unresolved. How can central banks "create" liquidity? How could central bank purchases of low-risk assets, such as US treasury obligations, affect liquidity in markets for risky assets?

In contemplating these questions, I came to believe the existing definitions noted above are incomplete with respect to critical characteristics of liquidity. Below I propose revised definitions, and then explain why I believe these create a more useful understanding of the term.

Market liquidity -- the degree to which market participants believe asymmetric information between buyer and seller exists with respect to assets offered for sale.

Funding liquidity -- the degree to which asymmetric information costs prohibit companies from meeting debt obligations without incurring significant value impairment.

Both of these liquidity definitions are premised on the role of asymmetric information in the market. When an asset owner knows more about the asset than a potential buyer, asymmetric information may prevent the transaction from occurring at fair value. This can occur for two reasons:

1) The classic "lemons" problem: The potential buyer believes the seller would only part with an asset at a price above its fair value. Therefore, the buyer requires an extra discount to mitigate such risk.

2) Owner dependent values: Some assets become more valuable with more informed owners. Loans to customers with whom a bank has an extensive relationship can be one example--such loans may be substantially less valuable to an investor less informed and less effective at responding to any delinquency situations.

Given these considerations, assets require greater risk premia as the available buyers are less informed.

When shocks hit markets or certain market participants must withdraw from trading activities (say a hedge fund experiences significant investor redemptions) fewer informed buyers exist. Central banks can respond to this problem by buying assets, such as US treasuries. You might wonder how buying US treasuries for cash could assist in added liquidity to risky investments. The answer lies, in my opinion, in how such central bank activities affect asymmetric information in the marketplace.

When central banks inject "liquidity" in the market, some investors previously holding US treasury securities now have available cash. Also, the central bank's buying activities has pushed prices of low-risk assets higher, lowering their related yield.  At the margin, investors now have greater ability (i.e. cash available) and incentive (i.e. less attractive yields in low risk assets) to become more informed regarding higher risk assets. 

As an example, consider an economy with three types of assets--cash, low risk treasury bonds, and high risk stocks. For simplicity, assume cash earns zero interest. As the central bank purchases treasury bonds, the economy experiences an increase in cash and a decrease in low risk bonds.  High risk stocks remain unchanged.  The yields of the low risk bonds also decrease due to central bank purchases.  These shifts result in two important observations:

1) Cash represents a larger percentage of assets held by investors. Since cash does not earn any income in this economy, it is reasonable to assume these investors are "looking" for ways to effectively deploy their cash holdings into income-earning assets.

2) high risk stocks become more attractive relative to low risk bonds--simply due to the decreased yields from the bonds.  

As a result of these observations, investors have more incentive to research the high-risk assets in search of income.  Said differently, central bank asset purchases encourage investors to lower the asymmetric information existing for risky assets. As investors perform research and asymmetric information declines, market liquidity and funding liquidity improve.

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