Saturday, January 03, 2009

How valuable is liquidity?

I enjoyed this though provoking post from Angry Bear (who I usually do not agree with):
I don't think that "market liquidity" is a good thing.

A sudden decline in the liquidity of assets can create problems as firms can't unwind leveraged positions without extreme market disruption. If the assets had always been illiquid, those leveraged positions would never exist. I think that would be a good thing.

Now there is a class of arguments that rational investors will take highly leveraged positions to profit from asset miss pricing and that this is socially desirable as they will drive asset prices towards their fundamental values. It is hard find these arguments convincing given the enormous increase in asset price volatility which has accompanied the enormous increase in gross long positions and gross short positions not to mention the huge increase in trading volume. My sense is that the average super smart highly trained trader is driving asset prices away from fundamentals. Thus I think honestly reported legal trading strategies are, on average, worsening the quality of the signals financial markets send to the real economy.
There is a specific sense in which the value of liquidity is overrated, or rather inverted, it becomes a toxic compound that degrade the financial sector as a whole, and that is when trading is structured in such a way that it can produce bank runs. In the Diamond-Dybvig model, long term assets financed by rolling over short term liabilities have two stable prices, one where you can roll over the liabilities, and one where you cannot. In practice, the state where you can roll over short term liabilities is unstable, once these assets fall, they cannot get back up.

You might be able to make an argument that the benefit you get from financing long term assets by rolling over short term liabilities is so great, that even if there is occasional disruption, the net benefit still makes the activity worthwhile. But given that the banking system has already lost more money than it ever made, and there are trillions that still need to be spent, the Empirics suggest that there is no net benefit, only net costs. In this spirit, Angry Bear and I have found common ground -- match the maturities of assets to liabilities and eliminate bank runs from the system once and for all.


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