The need for liquidity is a mantra among those who organise and regulate the financial system. To say that a proposal will damage liquidity more or less stops further discussion.
But what is liquidity? When I reviewed UK equity markets for the government last year, most participants told me liquidity was best judged by the spread – the difference between what it would cost to buy and sell the same share simultaneously. But since this is not a transaction anyone is likely to make, this indicator made little sense. Others regarded the volume of trading as a measure of liquidity; but this led to the circular argument that trading was good because it encouraged trading, a perspective relevant for those who own exchanges but not for anyone else.
The quest for liquidity rests on an illusion. Banks tell their customers they can have their deposits back immediately, even though they could not if all did so at once. It is often suggested that this confidence trick makes banking unique – banks have a mysterious capacity to “create money”. But the same device is used in many other markets to create an appearance of availability that exceeds the underlying reality.
I believe that I can catch the number 39 bus whenever I want to – and my experience bears this out – although the bus can accommodate only a small fraction of the people who not only live along its route but also hold the same belief in its availability. The electrical appliances in my home work whenever I flick the switch, although if everyone turned on their appliances at the same time the power system would let them down.
Efficiencies in capital provision are possible because individual demands are not perfectly correlated with each other. Bus companies and electricity suppliers carefully study correlations among the demands of different users and maintain a calculated margin of spare capacity accordingly. But the public benefit of that spare capacity exceeds its private value. So when reliability of supply really matters – as it does for electricity – regulators require more capacity than the industry might voluntarily choose.
If the volume of trade in electricity increased and the margin of spare capacity did not, or even declined, then the instance of blackouts would rise. Higher trading volumes thus reduce, rather than increase, effective liquidity. And high-frequency traders cannot, by the nature of their activities, provide liquidity in a relevant sense because they provide no capital: they close their books at the end of the day.
If we engineered the financial system with the same care and competence as the electricity network, financial crises would be less common. And yet electricity is special, because electricity is almost impossible to store. That leaves consumers especially vulnerable, and is the reason such care is taken to ensure that the system is robust and resilient. But it also makes the network relatively immune to panic buying. Most other commodities – food, fuel, money – can be hoarded, and that makes it important to maintain confidence in the competence of providers and the security of their supply chain. Events have proved we are justified in having confidence that the folks at Walmart and Exxon Mobil know what they are doing; they have given less reason to believe in the capabilities of those who run large financial institutions.
Yet money is differentiated from these other commodities in one important way – the government can print it; it cannot produce food or fuel, generate electricity or quickly build another number 39 bus. Paradoxically, this seems to have created less security for users of the financial system, not more, because managers and regulators who would otherwise have to take responsibility for its continued functioning know there is a backstop.
So the best measure of market liquidity is the degree of customers’ confidence that their requirements will be met. A supply chain is not fit for purpose when users install their own generators or hoard tinned food. A financial system is not working when potential users have banknotes under the bed or gold in the attic. An equity market is functioning effectively when users can operate with minimal cash in their portfolios. Liquidity is supply security not trading volume. What we call liquidity is often the umbrella that is missing when it rains.