Robert Waldmann

The word “liquidity” is slippery, since there is not a single solid agreed definition.

“Liquidity” refers to different things each of which is very important. I have long been fighting the suspicion that confusion of the various meanings influences the policy debate. I have lost the fight and now express the suspicion.

Briefly, I think that “liquidity” equivocations lead people to argue that high trading volume is unambiguously good. I don’t think that people who know the various meanings of “liquidity” are confused, but I do think that they have vested interests.

A semantic screed after the jump.

The core agreed meaning is that an asset is liquid if you can buy something with it right here right now. Cash is definitely liquid. Other assets, such as the balances of checking accounts, are very similar to cash. Such balances are counted in estimates of total “liquidity” here a synonym for “money.” So the first financial definition of “liquidity” is

1) Liquidity n. the amount of liquid assets or “money supply”.

This meaning is no longer current. It is the meaning of “liquidity” as used by Von Heyek and Von Mises. Excess liquidity is an excessive money supply. This old definition caused someone on the web somewhere to suggest that I was getting in touch with my inner Austrian when I wrote an earlier version of this post. I didn’t like that. But it isn’t a serious problem.

However, assets which are definitely not counted as money are called different things from not at all liquid (an entailed Feudal estate which could not be sold) to liquid (say a T-bill). This is a different meaning of the word liquidity giving the second financial defnition of “liquidity” is derived from the definition of “liquid”

2) Liquidity A property of an asset which indicates that it can be converted into money quickly and with low transaction costs.

This implies that if an asset is illiquid a rational person would not be willing to buy it intending to sell it again in the near future.

So liquidity is the notional property that corresponds to the adjective “liquid” which refers to assets and how quickly and cheaply one can convert them into money (liquidity is to liquid as redness is to red). According to this definition, money is perfectly liquid. Some other assets are very liquid.

This is based on the verb “Liquidate.” I think liquidate has a fairly clear meaning. It means “sell.” When one liquidates an asset one trades it for money, that is one “sells” it. I have no idea why people use a 3 syllable word when there is a perfectly good one syllable word. So a luquid asset is salable and has a lot of salableness.

But, you see delay and transactions costs aren’t the only problems for a seller.

People selling things are very unhappy when their market price has suddenly fallen. What if I can sell my asset right now, but I am extremely displeased by the price I am offered ? Is it less liquid ? Certainly not according to definition 2. Certainly according to people who say that the problem with financial markets is a loss of liquidity. This gives third definition

3) Liquidity the property of a price being as high as sellers think it should be.

This is clearly a magic pony definition. No asset has ever had that property. However, lots of people who have lost lots of other people’s money blame insufficient liquidity.

Between the problem of transactions costs (I’m thinking brokers’ fees and Tobin taxes and stuff) and the problem that the price of what I own is lower than I would like, there is the problem of market thickness. This is a huge issue for traders who take huge leveraged hedged positions. The problem is that the answer to the question “can I sell or “liquidate” my holdings of asset A quickly and get close to their value at the current market price ? ” depends on the answer to the question “how much do you want to sell ?” It turns out that demand curves for financial assets aren’t flat. Now it has been argued that, in theory, they should be. However, they aren’t.

For it to be possible to sell a lot of an asset quickly at its current price it is necessary that trading volume be high so that many are bidding and asking at near the current price. This gives a second definition of liquid (implying a third definition of liquidity).

4) Liquidity. A property of an asset which indicates that a large amount of it can be converted into money quickly at a price close to its current price.

Now the fourth kind of liquidity is only desirable to investors who make large trades. I rather doubt that Warren Buffet much cares about this kind of liquidity. He doesn’t make large trades often. I’d guess that when he wants a lot of something, he buys it slowly and quitly (up to 5% of it, that is, he’s a law abiding man). Notice also a certain circularity between this kind of liquidity and high trading volume. If people want to buy and sell large amounts of assts, they want other people to be willing to sell and buy large amounts of assets.

For some reason people in finance have decided to call markets in which assets are liquid, liquid markets. Thus liquidity is a property of a market and not of an asset.

5) Liquidity A property of a market in which assets are traded and large amounts of those assets can be sold and bought quickly at the current market price.

I prefer to call this property of markets “thickness.” Roughly a market is thick if there is high trading volume, a lot of buying and selling (that’s not all there is too it, since market orders add more liquidity than orders with reservation prices but I mean I’ve been struggling with one word for paragraphs give me a break).

Last I heard no one had managed to explain how financial markets can be liquid according to this definition of liquid (corresponding to the 5th definition of liquidity) without assuming that there are irrational investors called “noise or liquidity traders” who trade for no good reason. It sure sounds to me that the natural desire of traders for this kind of liquidity is a desire to have many sheep to fleece. Basically, it is good for them that many people are willing to buy at the current price, and many willing to sell, because they can bet against such fools and win.

I do not think that it should be an objective of public policy to make sure that professional traders have access to many fools so they can separate them from their money.

Finally ? there is a definition close to the first. We all know what someone means when they say “I have a cash flow problem,” they mean “I’m broke but I don’t want to admit it.” However, in theory, solvent firms (and individuals) can have cash flow problems. If they don’t have enough cash to cover their liabilities, but do own assets which will generate revenue whose present value (at some reasonable interest rate) is equal to the present value of their liabilities, they are called “illiquid but not insolvent.” They are said to have “a liquidity problem.” This is a fourth definition of liquidity

6) Liquidity N. fancy word for “cash flow”.

Somehow its about a flow not a stock, but its about having cash on hand.
The adjective “liquid” now refers to the entity not the asset or the market. An entity is liquid if it can cover its current liabilities. The alternatives are liquid and “out of cash right now.”

To be illiquid but not insolvent one must have illiquid assets. Typically these assets are things that can’t be bought and sold (“good will” and/or “wishful thinking”) or highly complicated assets which the firm with a cash flow problem swears are valuable but no one else has a clue.

I hope the final definition of liquidity is as the first name of mr liquidity constrained. An entity is liquidity constrained if it wants to borrow and no one wants to lend to it.

Now it is useful to understand “liquidity” these days because it has a lot to do with the financial crisis. For one thing, many people say the crisis is a liquidity crisis, that is, they say either that

a) the problem is that people have stopped buying and selling assets making them illiquid. This creates problems for firms which were planning to sell such assets in order to pay liabilities. For some reason all huge banks were planning to do that around now.

b) the problem is that assets have become illiquid *and* fear causes many market participants to want to liquidate them. The combinantion of a desire to sell and low liquidity implies a low price (according to def. 4 and especially 3).

c) Banks have to mark assets to market and satisfy prudential regulations. They have lost money so they have less capital (assets minus debt). Thus they have to liquidate assets and repay debt. Therefore they have to sell assets, but, those assets have become illiquid so they are in trouble.

d) Banks have a cash flow problem. They will be fine really. They just need a loan.

e) Banks are liquidity constrained. No one but the US Treasury is stupid enough to lend them money.

Now it is clear that if the problems were d or e, we would like more liquidity.

If the problems are a through c, maybe the problem is that assets which should never have been liquid were liquid. The argument that definition 3 liquidity (high trading volume) is definitely good, assumes that leveraged positions fall out of the sky. It is only the fact that traders knew they could unwind their positions (liquidate their assets and cover their short positions) that made traders willing to hold such huge long positions. However, they can’t all liquidate their position.

Liquidity is very dangerous if everyone thinks that he is smarter than everyone else. If all traders think that they will be the first to sell when the bubble bursts, they can destroy the financial system (look what they did).

Definition 3 liquidity is definitely good so long as everyone is rational. It is also impossible if everyone is rational (as far as market micro structure theorists can understand).

The argument that high trading volume must be good is a case of Schizzo finance. It is assumed that markets are efficient and all traders are rational. Therefore something which makes it possible for them to trade in some way must be good at least for them. It is also assumed that the optimal trading strategy isn’t to buy and hold the market. That basically requires the assumption that someone is irrational and markets are inefficient.

I think the logic of the financial sector has long been “We’re smart and there are plenty of dumb investors out there. The rules should be designed to make it easy for us to separate them from their money.” That is not a pleasant attitude, but, to our great misfortune, they were wrong. They managed to lose huge amounts of money making important institutions at least illiquid and probably insolvent.

Oh and don’t tell me that the many definitions of liquidity don’t have anything to do with a sector which makes money by confusing people and wants to make sure legislators don’t understand that this is their business plan.