Last week, the Bank of England held an ‘open forum’ to discuss what the financial sector contributes to the real economy.  I was part of a discussion of the role of liquidity. No topic illustrates more clearly the difference between the preoccupations of financial market participants and the needs of businesses and households.

The debate began from a practitioner’s definition of liquidity; ‘the ease with which one asset can be exchanged for another’.   The finance professionals bemoaned a widespread decline in liquidity, blaming the global financial crisis and the intensification of regulation which followed. In some markets, especially that for corporate bonds, they reported  almost  no liquidity at all.

But while the ease of exchanging one asset for another matters to traders, that is not the measure of liquidity which matters to savers. For them, security of their cash is crucial; they want to be able to get their money out of banks when they need it., they need to be sure that ATMs will continue to function. 

         Savers also need to be able to realise their assets in retirement and for major purchases.   But people saving for second homes or old age do not need a stock exchange in which shares are traded every millisecond.  The needs of these investors would be met perfectly adequately by a market which opened once a week.  Perhaps once a month, or once a year, would do.

So focussing on the needs of market users rather than market participants leads to a different perspective on liquidity. Corporate bonds are long term company obligations, mostly held by insurance companies and pension funds to meet their own long term obligations.  There is not much trade or liquidity in these markets because there is not much need for trade or liquidity in these securities.

The practitioner worried that  the absence of an active market damaged the process of ‘price discovery’. But ‘price discovery’ seems to mean something different from ‘value discovery’ – an estimate  of the expected cash flows which holders will derive from the security over its life .  ‘Price discovery’ owes more to the expectations of other traders than the fundamentals of valuation.  To believe that more can be learnt about the credit quality of a bond by stimulating trade in it than from careful evaluation of the circumstances of the issuer requires an unjustified faith in the ‘wisdom of crowds’  A lesson of the sub prime mortgage fiasco is that an active market in securitised products is no substitute for careful assessment of the borrower’s capacity to repay.

Regulation of open-ended investment products and of insurance and pension funds today  imposes requirements for marketability far in excess of anything required by the underlying needs of savers.  And the implicit and explicit restrictions these obligations  impose on investment choices damage  the interests of the retail customers the rules were initially intended to help.  

       Regulators then worry that savers might actually use the liquidity they are promised, but do not really need, by massive withdrawals from a single asset manager in whom they have lost confidence;  this fear is the basis of an argument for yet further regulation, involving the designation of large asset managers as ‘systemically important financial institutions’. And so the spiral of increasing regulatory complexity winds on.

Liquidity in financial markets is often equated to the volume of trade But every financial crisis demonstrates that  such liquidity is liable to evaporate when  actually required.  The assurance that the funding requirements of businesses and households can be met is best achieved by a resilient, well capitalised banking system  and an asset management sector focused on the long term needs of both providers and users of capital, not through a market characterised by  large trading volumes on low spreads.