Category / Liquidity and liquidity risk

Tony Lomas says March 5, 2014 at 4:38 pm

There’s something about doubly bisyllabic names. Jackie Wilson. Tony Lomas. They draw you in. Anyway, Tony has a corker re the liquidation of LBIE, the Lehman London broker/dealer: it turns out that it wasn’t a balance sheet insolvency that collapsed this entity, but [rather] a problem of liquidity, and Lomas expects there will be a £5B surplus at the end of the liquidation. LBIE started with £15B of capital, so that isn’t bad. The markets are discounting a distribution of this surplus, with LBIE receivables trading at 140. Honey chilli, you make my day indeed.

So what exactly is the rate you are borrowing at to fund that derivative? January 16, 2014 at 10:14 pm

As everyone who has been paying attention knows, JPM had a $1.5B FVA hit in their most recent results. Matt Levine riffs amusingly if sometimes a little inaccurately* about a couple of aspects of this, my favourite part being:

there is… some gap between “my funding cost” and “FVA.” It’s unclear to me how much of JPMorgan’s model is based on their own funding costs and how much is based on some “market” funding cost; the earnings deck talks about “market funding rates” and “the existence of funding costs in market clearing levels,” so it seems that they’re thinking more about a market price of funding than they are about their own cost of funding.

Oh one fun fact about that. That earnings deck says that FVA “represents a spread over Libor”; based on [JPM CFO] Marianne Lake’s comments you can guess that that spread is around 50 basis points. That is, banks fund at around Libor plus 50 basis points.

Libor, you’ll recall, is supposed to be the rate at which banks can fund themselves.

I will resist the temptation to add a smilie.

*Hint: when a lawyer rights about how exactly Black Scholes works, you might want to apply a pinch of salt. Or read a careful account of the story, for instance here or here (where the key role of the replicating portfolio is explained – although I buy the Albanese ‘not fungible with debt’ argument).

It’s the liabilities, stupid January 11, 2014 at 11:15 am

Jeremy Stein makes three good points:

Banks are almost always and everywhere largely deposit financed…

The asset side of banks’ balance sheets – and, in particular, their mix of loans versus securities – is considerably more heterogeneous… One interpretation of this is as follows: While lending is obviously very important for a majority of banks, it need not be the case that a bank’s scale is pinned down by the nature of its lending opportunities. Rather, at least in some cases, it seems that a bank’s size is determined by its deposit franchise, and that, taking these deposits as given, its problem then becomes one of how best to invest them.

Within the category of [banks’ investments in] securities, they appear to have well-defined preferences… it looks as if banks are purposefully taking on some mix of duration, credit, and prepayment exposure in order to earn a spread relative to Treasury bills.

With these liability-centric spectacles on, banking is a business of (1) attracting deposits and (2) figuring out something to do with them that reliably earns a spread to their cost. Credit extension is a consequence of this activity, not a core part of banks’ business model.

Liquidity, innit? December 1, 2013 at 2:46 pm

The ongoing debate about CCP collateral is interesting. The claim at its simplest is that even very good quality bonds – US T-bills for instance – are not perfect collateral because they cannot be turned into cash immediately. As Reuters reports:

Lawrence Sweet, senior vice president at the New York Fed, said last week that Treasuries could still pose risks to clearinghouse liquidity because payment for sales of Treasuries is not settled until the next day.

The idea, I think, is that if margin is 100% USTs, and a default happens, the CCP could absent other mechanisms (like lines of credit) find itself solvent but not liquid for a day. Market maker of last resort function anyone?

The slow reaction of bond indices November 5, 2013 at 6:41 am

From Goldman’s Jesse Edgerton, via FT alphaville:

In the current iBoxx US investment grade index, for example, about 15% of bonds in the index trade less than once a month, and only about 65% trade on any given day. Even fewer bonds trade multiple times per day in substantial sizes. Thus prices and yields for a large fraction of the bonds that are aggregated into published indices must be estimated by the providers of the index data each day.

Unfortunately, it appears that the procedures used to estimate these prices do not incorporate all information available on each day, because future movements in bond indices are easily forecastable well into the future. To illustrate, we regress daily changes from 2010 to present in the Bank of America-Merrill Lynch BBB index yield on contemporaneous and lagged daily changes in 5-year Treasury rates and daily changes in spreads on the 5-yr CDX index of corporate default swaps, a more liquid credit market instrument… Although information reflected in Treasury yields is incorporated into the index quickly, information in CDX spreads is incorporated very slowly. A 1 bp increase in the CDX spread accompanies only a 0.1 bp increase in the BBB index yield on the same day, but it predicts an increase of another 0.3 bps on the following day and further increases up to three weeks later.

This is more important than I have space for, really, so just a few hints:

  • This lag poses a serious methodological challenge to a lot of quantitative work which uses bond spreads – the delays need to be accounted for, and the slow response will be difficult to disentangle from other factors.
  • There might be the nub of an arbitrage here, if you could figure out how to do index arb safely on an index with illiquid components.
  • Issues like this may well get worse, as regulation makes market making more expensive. This is going to present growing opportunities for players willing to take asset illiquidity risk.

It can only be attributable to human error September 18, 2013 at 4:48 pm

Dave: Hello, Hal. Do you read me, Hal?

Hal: Affirmative, Dave. I read you.

Dave: Open the central bank window, Hal.

Hal: I’m sorry, Dave. I’m afraid I can’t do that.

This classic exchange, or at least my version of it, came to mind as I listened to an excellent talk by Hal Scott yesterday. Scott’s paper on Interconnectedness and Contagion is justly well-known. One of its theses is that contagion between financial institutions in a crisis might well be inevitable; that capital cannot reasonably be raised to levels where contagion cannot occur; and that liquidity risk similarly cannot be reduced to the point where runs on some class of financial system liabilities are impossible. Scott then argues that if this is true, then the FED has been shot in the foot by Dodd Frank’s restrictions* on who it can lend to in extremis. The lender of last resort function is the most important tool in killing contagion, Scott suggests, and as you don’t know a priori which class of institutions you will have to lend to, restricting yourself to banks is counterproductive. Resolution is a useful tool in dealing with the consequences of contagion, but wouldn’t it be better to have a wide spectrum antibiotic which can deal with the infection rather than an efficient funeral and burial service?

Perhaps, then, one of Hal’s best lines should really be spoken by the architects of the Dodd Frank restrictions on who can access the FED window:

I know I’ve made some very poor decisions recently, but I can give you my complete assurance that my work will be back to normal. I’ve still got the greatest enthusiasm and confidence in the mission. And I want to help you.

*Section 1101 of the Dodd Frank Act, Federal Reserve Act Amendments on Emergency Lending Authority, since you ask. And Section 716 restrictions on lending to swap entities for that matter.

What is a run on a CCP? September 13, 2013 at 1:21 pm

The term ‘run on a CCP’ has been bandied around a fair amount, but it isn’t entirely obvious what it means. Let me attempt to shine some light onto the idea.

A run on a bank occurs when depositors withdraw deposits quickly. In the days before deposit insurance, bank runs from retail depositors were common as their money was genuinely at risk from bank failure. These runs were damaging as banks which were solvent but not sufficiently liquid (due to demand deposits funding term loans) could fail due to a run. These days, bank runs occur in the wholesale funding market: hence Gorton and Metrick’s influential paper about the run on repo in the 2008 crisis. These repo runs occur if wholesale funders refuse to carry on providing liquidity.

Hence a run on a CCP can happen if the CCP’s counterparties withdraw liquidity quickly, and the CCP cannot liquidate assets fast enough to keep up with the liquidity demands on it (or can only do so at great cost).

What’s different about CCPs is that this can happen in two ways.

  1. If clearing members neutralise their risk quickly, CCPs have to repay initial margin. That initial margin might have been provided as cash but invested by the CCP in securities. Therefore this kind of run – a run on IM – occurs when the CCP cannot liquidate investment assets fast enough to repay IM. CCP investment mandates are designed to reduce the risk of this happening.

    Of course, one way that this can happen is if clearing members move their risk to another CCP. If clearing member house portfolios are regularly compressed, then moving the house account may not be that difficult a matter. Hence the risk of a large clearing member moving its risk from one CCP to another clearing the same products is non-zero.

    (One could imagine this happening for instance because confidence was waning the CCP, or because the CCP’s ‘qualifying’ status was in doubt, leading to the possibility of higher capital requirements for its users.)

  2. A less obvious but equally risky run mechanism (a route for a run?) is collateral substitution. As yield curves normalise over the coming years, the incentive to hold margin in the form of securities vs. cash will change. Term securities may look more attractive, resulting in clearing members substituting securities for cash in margin accounts. This can create liquidity pressure too as the CCP has to liquidate what it has invested the cash in to refund it. There is a case in this context for limiting the speed at which clearing members can substitute non-cash for cash margin.

Time will tell if these risk vectors do indeed threaten CCPs. But until we know more, alertness to potential CCP liquidity risks is vital.

Getting out of three trillion August 27, 2013 at 7:32 pm

What do you do if, in round terms, your balance sheet is three trillion dollars bigger than you want it to be? (Or two. Whatever.) Get into the reverse repo market in a big way, of course. Which is exactly what the FED is doing, as the WSJ spotted:

In the July minutes of the Fed meeting released Wednesday, officials discussed a proposal to introduce a so-called reverse repurchase program

That would be a fixed-rate, full-allotment reverse repo programme, to flesh out the details and correct the WSJ’s lamentable spelling. The idea is to give the FED better control over that key monetary policy transmission mechanism, the repo market, by allowing them to dribble out collateral as needed to meet their target repo rate (or more precisely spread of repo rate over FED funds).

Just one question. If Barclays are right about the impact of recent regulatory proposals on the repo market, might the FED be picking up a new tool just when it is about to become less effective?

Tarullo prudently prepares May 5, 2013 at 5:13 pm

FED governor Daniel Tarullo gave an interesting speech recently; interesting because he is clearly trying to set out a regulatory agenda while uncomfortably aware that legislators, if anything like Brown Vitter is passed, might pull the rug out from under him. He therefore has to tread delicately. That doesn’t stop him from pushing the FED’s line, but they are gentle nudges.

His first real point is that liquidity reform has not made much progress:

we have not yet adequately addressed all the vulnerabilities that developed in our financial system in the decades preceding the crisis. Most importantly, relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs… But significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions.

He has to admit that little has been done about too big to fail as it hasn’t, and the Senate has noticed

With respect to the too-big-to-fail problem, as I noted earlier, actual capital levels are substantially higher than before the crisis, and requirements to extend and maintain higher levels of capital are on the way… But questions remain as to whether all this is enough to contain the problem.

Indeed. He gives the standard spiel on more capital and/or liquidity risk regulation, as in Basel III. But then it gets interesting:

a second possibility that has received considerable attention is a universal minimum margining requirement applicable directly to SFTs.

Or, for that matter, a tax on them. Either would do.

Look at this for a lovely piece of politics. Tarullo says, as he would, that the FED should be allowed to complete its current agenda. But then he pays deference to the law makers:

the first task is to implement fully the capital surcharge for systemically important institutions, the LCR, resolution plans, and other relevant proposed regulations. But, completion of this agenda, significant as it is, would leave more too-big-to-fail risk than I think is prudent. What more, then, should be done? As I have said before, proposals to impose across-the-board size caps or structural limitations on banks–whatever their merits and demerits–embody basic policy decisions that are properly the province of Congress

That leads him to trying to head the B-V posse off at the pass:

One approach is to revisit the calibration of two existing capital measures applicable to the largest firms. The first is the leverage ratio. U.S. regulatory practice has traditionally maintained a complementary relationship between the greater sensitivity of risk-based capital requirements and the check provided by the leverage ratio on too much leverage arising from low-risk-weighted assets. This relationship has obviously been changed by the substantial increase in the risk-based ratio resulting from the new minimum and conservation buffer requirements of Basel III. The existing U.S. leverage ratio does not take account of off-balance-sheet assets, which are significant for many of the largest firms. The new Basel III leverage ratio does include off-balance-sheet assets, but it may have been set too low. Thus, the traditional complementarity of the capital ratios might be maintained by using Section 165 to set a higher leverage ratio for the largest firms.

The other capital measure that might be revisited is the risk-based capital surcharge mechanism. The amounts of the surcharges eventually agreed to in Basel were at the lower end of the range needed to achieve the aim of reducing the probability of these firms’ failures enough to offset fully the greater impact their failure would have on the financial system. At the time these surcharges were being negotiated, I favored a somewhat greater requirement for the largest, most interconnected firms. Here, after all, is where the potential for negative externalities is the greatest, while the marginal benefits accruing from scale and scope economies are hardest to discern. While it is clearly preferable at this point to implement what we have agreed, rather than to seek changes that could delay any additional capital requirement, it may be desirable for the Basel Committee to return to this calibration issue sooner rather than later.

Is this just trying to kick the can down the road? Tarullo must know his chances of getting higher standards agreed in Basel are low. Equally he knows that unilateral action in the US will damage the competitiveness of US banks (while making them safer, of course). If he can’t persuade the Brown-Vitter crew to back off, and he can’t get Basel to agree to similar standards, he will have to doff his cap and do what the law requires. I would suggest, though, that that doesn’t mean that he will like it.

Equity, debt, freezers and TVs April 29, 2013 at 9:37 am

My freezer is like equity, my TV is like debt.

Let me explain.

There is a push from electricity suppliers to distinguish appliances that need their power now – like TVs – from those that can wait a few minutes – like freezers. We might even imagine a situation where there are two types of plug connecting to two (virtual) networks with two tarifs: an expensive, power-on-demand one; and a cheaper, give me power when you can one (with some standard over how long it could be delayed etc.) This would typically be achieved using smart devices, so my freezer would say to the network that it needed half a kilowatt hour of electricity sometime in the next ten hours, and the network would deliver it when convenient, given the total load. The plug would contain a network as well as a power connector allowing the freezer to talk to the grid.

This allows much better peak management. You can deny power from freezers in that critical five minute commercial break at half time in the cup final, giving you a better chance of boiling all those kettles.

The problem with debt is not just that it is leverage, but also that it is demand liquidity. The debt holder can demand their payment now. (Thus contingent liquidity schemes like lines of credit are like pumped storage power: they allow a solvent but illiquid party to meet peak liquidity demand.) The two tarif idea is akin to suggesting that there is a place for delayable payment but otherwise senior contracts – like sub bonds but where it is genuinely acceptable to use the deferral feature. Indeed, Islamic finance has always had such an idea, and many firms in practice treat supplier invoices that way. The nice part about the smart freezer though is that there is in some sense a negotiation between the freezer and the grid: could we imagine a similar ‘I need $1M sometime in the next two days… OK I will get it to you on Tuesday at 7.30am’ idea in finance?

Downing Drysdale April 9, 2013 at 12:18 am

Scott Skyrm helpfully reminds us of an historic failure, that of Drysdale. The origin of the failure was a glaring arbitrage between the US repo market in the 80s and the treasury market. The former did not account for accured interest on repo’d t-bills, while the latter did. Drysdale’s head trader

started short-selling U.S. Treasurys outright, where he received the price plus the accrued interest. Then he borrowed the securities to cover his shorts in the Repo market, paying only the market price. He was getting the full use of the accrued interest on the bonds at no cost. In order to maximize to amount of cash he was collecting, he concentrated on shorting Treasurys about half way between the semi-annual coupon payment dates. With years of declining bond markets, he had made a lot of money shorting the Treasury market and by February 1982 his trades reached $4.5 billion in short positions and $2.5 billion in long positions… Overall, it was not a bad trading strategy since he won under two out of three possible market scenarios. If the bond market went down, he made a lot of money. If the market stayed the same, he earned free interest on the cash the trade generated. [But] If the Treasury market rallied, he risked a significant amount of money.

The problem, then, was that he was exposed to rising prices which would kill his short. Needless to say, that happened in spring 1982, and Drysdale collapsed. What happened next is insightful.

Drysdale had conducted their Repo trading mostly through Chase’s Securities Lending Department and Drysdale’s counterparties believed they were facing Chase and not Drysdale. Chase believed they were acting “as agent” for Drysdale, so they would not accept responsibility for the $160 million in coupon interest payments on that Monday, but the problem grew even worse. Up until then, the government securities market had operated under the assumption that the buyer in a Repo trade was entitled to liquidate the trade in the event of a default by the seller. There was no law on books differentiating a Repo from a collateralized loan and there had never been a case in court to set a precedent. The market was unsure whether they could liquidate the Drysdale/Chase Repo trades.

The lack of clarity as to the bankruptcy status of a Repo left Chase with a major dilemma. If the bank refused to pay the coupon interest to the Street and that contributed to any of those securities dealers going bankrupt, a future court ruling against Chase could expose them to liability for the damage they caused. However, if Chase made the coupon interest payments for Drysdale, they were clearly taking a loss and would line up as a creditor of Drysdale in the bankruptcy. It was a lose/lose situation.

On Wednesday, the Fed intervened and called together the heads of the 20 largest banks and securities dealers for a meeting at the Fed’s New York office. Not only was there pressure put on Chase from the dealer community, but also by the Fed itself. Though the Fed would later announce that their only involvement was hosting a meeting, quite similar to the future meetings for Long Term Capital Management in 1998 and Lehman Brothers in 2008. The next day Chase relented and, as they say, the rest is history.

The FED, then, prevented a market failure by leaning on Chase in the way central banks do. There were profound financial stability reasons for doing this, not least because of the uncertainty in the legal status of repo. Without knowing if a repo was a collateralised loan or a sale/buyback, no one knew what the exposure was. The law was subsequently clarified in favour of the latter interpretation (thanks to another bankruptcy Scott discussed, that of Lombard-Wall), but the lesson is clear: don’t engage in lots of transaction of uncertain legal status.

Collateral = risk capacity January 29, 2013 at 10:26 am

US GC repo is going lower, because, well, the Treasury has most of the assets, thanks to QE. Given that these assets are needed for collateralised funding and collateralised risk taking, that is having an impact. Izzy at Alphaville relays the following, very much along the line we have taken on this:

overly strict collateral policy, implemented post crisis, is now constraining the market’s ability to take on risk, because the ability to fund or run “risk-on” trades is determined by how many safe assets an institution has available for margin posting.

Risk positioning is increasingly being held back by a static pool of risk-free collateral.

Furthermore, if and when the risk positions sour, that divide only gets wider as further safe collateral calls are made, sucking more safe assets out of the system.

You can’t both demand that funding and risk taking are often collateralised then buy up most of the collateral without it having an impact.

‘Maintaining Confidence’ paper is up January 8, 2013 at 6:11 pm

My paper Maintaining Confidence – Understanding and preventing a major financial institution failure mode has been published as an LSE Financial Markets Group special paper, and is available here. From the abstract:

This paper proposes the solvency/liquidity spiral as an failure mode affecting large financial institutions in the recent crisis. The essential features of this mode are that a combination of funding liquidity risk and investor doubts over the solvency of an institution can lead to its failure. We analyse the failures of Lehman Brothers and RBS in detail, and find considerable support for the spiral model of distress.

Our model suggests that a key determinant of the financial stability of many large banks is the confidence of the funding markets. This has consequences for the design of financial regulation, suggesting that capital requirements, liquidity rules, and disclosure should be explicitly constructed so as not just to mitigate solvency risk and liquidity risk, but also to be seen to do so even in stressed conditions.

Homeopathic regulation January 7, 2013 at 2:47 pm

The new revisions to the Basel III LCR do not, of course, water it down to homeopathic quantities, but I love the phrase so much I wanted to use it nonetheless.

Basel proposes:

  • the definition of high quality liquid assets (HQLA) has been expanded to include lower-rated corporate bonds (A+ to BBB-);
  • certain equities with 50% haircut
  • as well as certain RMBS rated AA or higher with 25% haircuts.
  • The aggregate of these additional assets are subject toa limit of 15% of the HQLA.

The Basel Committee has also agreed to a timetable for phase-in of the new standard. Banks’ LCR will need to reach 60% in 2015, increasing by10% p.a. until 2019, instead of a 100% requirement in 2015.

My snap judgement is that this can probably be met by most banks in the current liquidity environment. Whether it will act as a constraint later is less clear.

The repo safe haven December 2, 2012 at 6:23 am

From a presentation by Eurex Repo:

GC Pooling − Take advantage of collateralized funding


• Zero regulatory costs due to trading via Eurex Clearing depending on country of residence

This is entirely accurate, I am sure. But should it be? As I said earlier, the idea that repo, especially repo with `Re-use of collateral and pledge to ECB’ of those notoriously safe assets, European sovereign bonds (cf. Fuzzy Corzine, late of this parish), attracts no capital at all worries me. I’m pretty sure that this door will only be bolted well after the horse has fled, though.

Wot about repo? November 19, 2012 at 2:18 pm

Like many, I am reading the FSB report on shadow banking. The most important issue here is the fifth workstream, securities lending and repo — yet the proposals seem, well, a little bland. Here are the suggestions in brief:

  1. Improving regulatory reporting
  2. Improving market transparency
  3. Improving corporate disclosures
  4. Improving reporting by fund managers to end-investors
  5. Introducing minimum standards for haircut practices
  6. Limiting risks associated with cash collateral reinvestment
  7. Addressing risks associated with re-hypothecation of client assets
  8. Strengthening collateral valuation and management practices
  9. Evaluating the establishment or wider-use of central clearing where appropriate
  10. Changing bankruptcy law treatment of repo and securities lending transactions

All good stuff, but if a money market fund requires something like capital because it is bank-like, shouldn’t there be capital requirements for all repo rather than Basel II’s safe harbour (zero capital for certain qualifying transactions)? And, if not, on what basis is liquidity risk being `traded off’ against systemic and credit risks? Just askin’.

Terrifying question of the day October 24, 2012 at 8:17 am

(Yes, that is a theme for this week. I’ll get over it after that.)

Can a Basel III liquiidity buffer every be used? The point is that banks have to have this buffer at all times, which means that they can never use it without triggering supervisory intervention. So do they in fact have more liquidity risk than prior to Basel III?

Pricing and marginning liquidity risk September 22, 2012 at 8:53 am

Back in the mists of time, I heard about a trade whereby a Japanese fund paid an investment bank a (small) fee in exchange for the promise that they would make a quote on a large portfolio of illiquid equities if requested to do so. The bank didn’t promise to quote ‘at market’, just that they would quote. They could have quoted a single yen, but of course there would have been serious reputational implications to doing that, especially in Japan. So in effect the fund was paying for a liquidity risk backstop.

This came to mind when I read this post on a Sober Look about differences between bilateral and triparty repo haircuts during the crisis:

When a firm lent money to Lehman via repo on a bilateral basis, Lehman placed the collateral for this loan into the lender’s securities account – at Lehman. Once Lehman filed for bankruptcy, it would not pay back the money borrowed. The securities account where the collateral was sitting however was frozen by the court. By the time the lender was able to access her collateral and sell it, it had sometimes declined in value so much that the proceeds did not cover the loan balance.

On the other hand if the collateral was held by a third party such as State Street or BoNY, as soon as Lehman couldn’t pay, the lender was able to access and liquidate the collateral. Thus the differences in haircuts are not driven by the repo agreement itself… It’s driven by the fact that in a bilateral agreement it may take longer to access the collateral and liquidate it, potentially increasing losses. That risk of a longer liquidation period in the case of a default increased the bilateral haircut levels.

The difference between bilateral and triparty haircuts, in other words, represents a kind of liquidity risk premium. You could either deal with this in margin, or get paid a fee to take the risk in a bilateral repo that the triparty margin wasn’t adequate – as in the ‘pay for a quote trade’. You could even support the risk with capital. But in any case there is a risk there that needs to be understood, managed, and for which the risk taker requires a return.

What is liquidity in a financial asset and why would you want it? September 12, 2012 at 3:25 pm

Lisa at FT Alphaville, linking to some Citi research, suggests that there are the following measures for bonds. The italics are Lisa’s comments; mine are in roman.

  1. Absolute number of block trades. These are defined as a trade size of over $5m for high-grade bonds, and $1m for high-yield. Once they have the count over the last 60 days, they logarithmically rank them within their own sector (high-grade or high-yield).
  2. Consistency of block trading activity. Consider the first factor more closely — if there were, say, 45 block trades in the 60-day window but they were all on one day, that doesn’t exactly shout liquidity! If, on the other hand, the trades were spaced out, that’s probably a better sign. This factor also involves a logarithmic ranking.
  3. Why would you want it? Well, if you needed to sell. That much is obvious. What is perhaps less obvious is that high quality but illiquid assets are good for some investors, like pension funds, who are often hold to maturity, and who can get paid to take illiquidity risk. Indeed arguably pension funds should not be invested much in liquid assets at all as they are paying for liquidity that they don’t need. What everyone needs to know, though, is whether they are receiving sufficient compensation for the liquidity risk they are taking. These measures at least help in that judgement.

  4. Client trading activity. This is where the Citi strategists start to get creative, and where it also becomes apparent that they are building this liquidity measure for their clients. Here they count up the number of trades that actually involved a client rather than just the Street selling to the Street, i.e. client-to-dealer rather than dealer-to-dealer. Additionally, they adjust this variable by factor 1) above.

    This makes sense; interdealer pass the parcel can easily go away, whereas genuine two way client flow is more durable.

  5. Market balance. This is a measure of the amount of two-way activity seen in the client trades of the previous factor. If there are as many client buys as sells, then it’s more likely that trades can be executed without moving the market. This factor is also weighted by 1) above.

    A thousand sellers and one buyer, even if all the trades clear is likely not durable liquidity; if the buyer exits (cf. ABS CDOs buying RMBS mezz tranches) then the market disappears.

  6. Compensation for non-default-related spread volatility. This (pace Alphaville) is straightforward; if the liquidity premium is highly variable, then the market is patchy, whereas if it is more or less constant, then prices only move when there is a change in fundamentals. This isn’t pure liquidity, but it is correlated with trading activity, so it is a useful measure.

It is commonplace to add to these additional measures:

  1. Price impact of a trade. Roughly, how much you move the market when you do a big trade.
  2. Recovery time. This is simply how long it takes prices to recover after a ‘big’ trade hits the market, whatever ‘big’ means.
  3. Bid/offer spread. Lower spreads tend to mean better liquidity.
  4. Quote availability. While a quote does not mean that you can trade, no quotes tend to imply that it is harder to trade.

Collateral damage August 16, 2012 at 6:30 am

Four telling graphs, from a great presentation by Citi’s Matt King (HT FT Alphaville).

First, the importance of the repo market:

Repo importance

Second, the growing importance of collateralized borrowing (and the decline of the interbank market):

Repo vs Unsecured

Third, the trend towards the use of ‘safe’ collateral:

Safe Collateral

Fourth, where the bad stuff ends up:

Unsafe Collateral

So… what do we have? It’s hard for a bank to borrow unsecured. It’s hard for it to borrow secured in the private market unless they have the best collateral. But, riding to the rescue (kinda), is the ECB, where you can pledge some of that dodgy collateral. This state of affairs is not sustainable in the long term, though; we need to do something to get banks to trust each other again.