Valuing Liquidity

Liquidity is the least-respected credit facility in the financial sector. It is treated in a cavalier fashion both by many users and suppliers. It is priced as a low-risk product when it is high risk. It is assumed to be available when needed, despite the fact that there are limits on its availability. And many do not recognize they require liquidity to execute efficiently their payment and securities transactions.

Charging for liquidity has never been a science. The problem with liquidity is that a single entity can be long and short of liquidity in a single day. Many argue that the expectation to charge for debits has logically to be balanced with an ability to be paid for credits. But that is nonsensical. Current accounts rarely pay interest, but they charge on overnight debit balances. Admittedly, flows over current accounts with overnight charging are easier to manage than those that occur intraday and minute by minute; but intellectually the concept is little different.

So what is the cost of liquidity to banks? At one level they hold free balances, mainly through their provision of current account services. But those free balances cost to maintain and are only free in the sense that the cost is operational and not interest related. The banks may have free intraday balances from minute to minute due to flows over their accounts. And they may have purchased liquidity where they have funded longer-term structural liquidity gaps, often based on peak demand, by term borrowing matched to short-term, often overnight, lending.

Such purchased liquidity (and parts of bank capital) may also be deployed in high-grade instruments (invariably short-dated governments) that can be sold and repurchased to create liquidity as well. The key is that all these transformations cost money, either by reference to the yield curve prevailing between the loan and deposit or through the operational cost of providing the product generating the liquidity.

Liquidity is going to be more in demand as we move forward. TARGET2-Securities (T2S), as an example, requires funds or collateral to be in place by early evening the day before settlement for any related transactions to be allowed into the overnight batch process. And, if operators wait for the daytime process, then settlement-system liquidity demand would have to compete with real-time gross settlement payments and other markets.

Illiquidity is not technically the cause of defaults. It is, though, the final symptom. In reality, financial-sector firms rarely become insolvent. They become illiquid and unable to fund themselves. At that point their assets change from having a value based on normal markets or the price at maturity to being priced as forced sellers or refinancers. In other words, illiquidity and insolvency are synonymous.

So what are the risks to the giver of liquidity? In effect liquidity provision is an advance, admittedly for a short period and thus lower risk than its lengthier brethren. The source of repayment for liquidity will be completion of the relevant transaction. At a securities level, that means receipt of the funds from client through the transaction chain to the provider of liquidity. At a payment level, it depends on a similar flow from originator through the entire transaction life cycle. Obviously there are added buffers against failure. These can be capital or facilities available to the demand side outside of their payment bank. But, with a financial market assessing risk in an ever-more-uniform way and capital not necessarily being held in sufficient liquid amounts to provide more than a marginal added barrier, the gap between supply and demand is much narrower than many would suspect.

There is a risk that shortfalls in liquidity will impact settlement efficiency and that such delays will expose, especially at times of crisis, the demand side for liquidity to material risk. Surely the markets need to look at the term availability of liquidity rather than depending on the day-to-day provision of what is, after all, the lifeblood, especially of the broker-dealer or prime brokerage industry. Is there, though, a willingness among suppliers to provide, say, a three-month rolling liquidity facility in the quantum needed to such firms? And what spread over cost would they apply? The worry is that the cost and challenge of supply is precluding the demand side from ensuring their providers are committed. The downside could be that the next liquidity crunch makes Lehman look like a walk in the park!