Tuesday, February 9, 2016

A Long View on Liquidity

The interview was first published by the Global Association for Risk Professionals on February 04th 2016

Concerns about market liquidity and related crises are nothing new, but memories are short, says NYU’s Yakov Amihud

Yakov Amihud, the Ira Leon Rennert Professor of Entrepreneurial Finance at the Stern School of Business, New York University, has been studying liquidity for more than three decades. He is the coauthor of “Market Liquidity: Asset Pricing, Risk and Crises” (Cambridge University Press, 2013). His recent work has been around pricing illiquidity, illiquidity premium and liquidity risk of corporate bonds – at a time when liquidity issues are of growing concern among fixed-income market participants and regulators.

Institutions need “built-in mechanisms and standards to ensure that investments are made in assets that can be liquidated at the lowest possible cost,” says Yakov Amihud of NYU’s Stern School.
“If a bond is liquid, the company can sell it at a quarter point less. That is equivalent to the central bank lowering interest rates by a quarter points,” Amihud says. Although his first paper on the subject, “Liquidity and Stock Returns” (with H. Mendelson), was published in May-June 1986 (Financial Analysts Journal 42, pages 43-48), he believes that liquidity risk naturally captures attention in the aftermath of a crisis – as it did post-2008.

Amihud focuses his research on the effects of stock and bond liquidity on the assets’ returns and values, and on design and evaluation of trading methods in the securities markets. The New York Stock Exchange and Chicago Board Options Exchange are among the markets he has advised.

In this interview with GARP Risk Intelligence contributor Nupur Pavan Bang, the professor discusses liquidity risk, difficulties in assessing it and what the U.S. corporate bond market can learn from the Indian corporate bond market.

Why wasn’t the world of finance paying much attention to liquidity before 2008?
My research shows that the pricing of liquidity becomes more important after crises. As with a natural disaster like a hurricane or earthquake, people buy Insurance after the event. The next year and the following years, if the disaster does not repeat, they may not renew the insurance. Similarly, when a liquidity crisis happens, people say, “Wow, this is important and we should take it into consideration.” But they soon forget about it. And when the crisis hits again, they are not prepared for it.

What previous events may have been forgotten?
There were multiple occasions. During the crash of 1987, the Dow fell by approximately 25% in a single day, and during the crisis of 1998, liquidity was scarce worldwide. There were always more than single reasons for each of these events. However, illiquidity of assets also remains an important reason for the losses.

The collapse of Long Term Capital Management in 1998 is also attributed to illiquidity. LTCM had good positions. It’s just that the market did not have the liquidity to absorb the trades that would result from unwinding LTCM’s positions.

In spite of these historical events, which clearly pointed towards the perils of not taking liquidity risk into account, we have clear evidence of people forgetting. In “The Big Short” by Michael Lewis (2011), pages 216-218, the author recreates a conversation between John Mack, the CEO of Morgan Stanley, and investors on December 19, 2007, explaining the trading loss of $9.2 billion:

Mack: This was the result of an error in judgment incurred on one desk in our fixed income area, and also a failure to manage that risk appropriately . . .

William Tanona, from Goldman Sachs: “…I am surprised that your trading VaR stayed stable in the quarter given this level of loss, and given that I would suspect that these were trading assets. So can you help me understand why your VaR didn’t increase in the quarter dramatically?”

Mack: Bill, I think VaR is a very good representation of liquid trading risk…

The risk management tools assumed that the assets can be bought and sold indefinitely without changes in the price. Now that is ignoring liquidity risk completely. So people had really forgotten lessons from the past. I hope people will be more sensitive towards the issue now.

With more commentators and experts talking about it, let’s say people want to tackle liquidity risk. What can actually be done about it?
You and I will not face the problem of liquidity risk, but the institutions which invest large amounts of money will. When billions of dollars are being invested by a single institution, the investment needs to be designed in such a fashion that assets can be liquidated at minimum cost.

Think about it. If the government does not force people to meet certain standards and build an earthquake-proof home, they will not do it. They will look at it as an unnecessary expense. Even in places that are declared to be high-risk zones, people don’t build earthquake-resistant houses. Similarly, an investment may look good on paper and may perform well in good times. It may not do so during periods of crisis. So the Institutions need to have built-in mechanisms and standards to ensure that investments are made in assets that can be liquidated at the lowest possible cost.

What is the problem with corporate bonds in the U.S.?
In the U.S., traditionally the corporate bond market is not very transparent. There is no centralized marketplace where one can see the quotes or post quotes. If you look at the equity markets, NASDAQ or NYSE, it is all electronic and automated trading. Thirty years ago, you would see hundreds of market makers sitting by telephones, providing quotes and taking orders. In the equity markets, they are all gone now. Electronic trading has brought about greater transparency and more liquidity. The cost of capital in the equity markets has gone down.

People say that the U.S. corporate market is not liquid because small investors avoid it. I would say that it is a chicken-and-egg story. Investors avoid it, and it is not liquid, because it is so difficult to trade. In fact the U.S. can learn from India here. India has automated electronic trading platforms for corporate bonds as well.

This is not a question of helping the traders or investors. It must be done for the economy. It must be done to help companies raise capital at a lower cost. Research shows that if a bond is liquid, the company can issue bonds at a lower interest cost. Therefore, the people designing trading systems need to think about this and how to help businesses access the market to raise capital at lower cost. And if the private sector does not do that, the government should help this happen, because greater liquidity generates widespread positive externality in capital markets that the developers of the trading system cannot fully capture.

What kind of impact would the Fed’s recent rate increase have on liquidity?
It is true that when there is a shortage of funds, liquidity problems become serious. But I don’t think the quarter percent increase will have much impact.

In India, the central bank under Raghuram Rajan lowered interest rates one percent in 2015. Will a downward trend in India and an upward trend in the U.S. result in a flight of money to the U.S.?
Not necessarily. If the rate reduction in India brings about greater economic growth and more robust business activity, then the flows from U.S. to India may continue and even grow. Inflation should also be looked at. Investors look at real rates in the end. The strength of the currency must also be assessed. The impact of interest rates must be looked at holistically.

Regarding your work on entrepreneurial finance – in India, many startups have raised money from angel investors or venture capitalists at very large valuations, but they are not making money. What are the prospects for exits or liquidity to enable transactions of any kind?
Amazon wasn’t making money for years and years. The market looks forward. It looks at the potential. If Amazon could get valued at billions of dollars without any profits, so can the startups in India. About liquidity before IPO, in the U.S. there is a platform called Second Market that facilitates private transactions in non-public equity claims. This helps the VCs and other funds and investors to trade in the shares of VC- and private-equity-backed ventures. The greater liquidity in these claims, enabled by this and other, similar trading platforms, makes it more feasible for entrepreneurs to raise capital at lower cost.


There are problems with respect to information asymmetry. But it is something that has been improving over time and continues to improve. Something similar in India will be helpful for both the startups and the investors.
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