Thursday, October 18, 2007

. David Longworth: "Liquidity, liquidity, liquidity", Bank of Canada

Memo to liquidity watchers worldwide: do not miss this speech by David Longworth, Deputy Governor of the Bank of Canada. "Liquidity", says Mr. Longworth, "is one of those words that are used to mean slightly different things in different contexts". There are three concepts of liquidity that are relevant to the world of finance: [1] macroeconomic liquidity; [2] market liquidity; [3] balance-sheet liquidity. Macroeconomic liquidity has to do with "overall monetary conditions", including interest rates, credit conditions, and the growth of monetary and credit aggregates.

This concept, in turn, can be seen from a domestic and from a global perspective. From the domestic point of view, Mr. Longworth singles out the monetary base as the key central bank tool to influence short-term interest rates. He says little about global macroeconomic liquidity, although he remarks that "one can aggregate macroeconomic liquidity across countries to obtain average world real interest rates and the average growth of monetary and credit aggregates". From the perspective of the Global Liquidity Blog, the truly interesting part of the speech starts with the definition of market liquidity.

Market liquidity & the "Great Moderation"
"Liquidity", says the Deputy Governor, "is the lifeblood of markets ... [It] is essential to the well-functioning of both the real economy and financial markets". The more liquid the market, the better — with an important caveat: complacent investors may be tempted to take on too much risk. Mr. Longworth then proceeds to define market liquidity:

Market liquidity refers to the extent to which one is able to quickly and easily buy and sell financial assets in the market, without moving the price. Market liquidity captures the aspects of immediacy, breadth, depth, and resiliency in markets. Immediacy refers to the speed with which a trade of a given size and cost can be completed. Breadth, often measured by the bid/ask spread, refers to the costs of providing liquidity. Depth refers to the maximum size of a trade for any given bid/ask spread. Resiliency refers to how quickly prices revert to fundamental values after a large transaction.

Several factors help to explain the tremendous growth in market liquidity over the past 15 years: the appearance of new players such as hedge funds, financial innovation (derivatives, CDOs), the growth of electronic trading, back-office innovations. But here's —at least from my perspective— the key statement of the speech:

... efficiency gains in the financial sector, better inventory management, and better macro policy – including monetary policy – resulted in what has come to be called the "Great Moderation," which was a significant reduction in the variability of output, inflation, and long-term interest rates across most G-7 countries, starting in the mid-1980s. And this moderation has, in turn, contributed to the liquidity of financial markets by reducing some of the fundamental sources of financial volatility and risk.

Bingo! This is the very raison d'ĂȘtre of our own Endogenous Liquidity Index! The rest of the speech is devoted to "recent events around the world". Note the connection between market and macroeconomic liquidity: as credit markets froze in the second week of August, "the rate on overnight collateralized transactions moved above the target overnight rate". This forced the central bank to inject macroeconomic liquidity in order to avoid sharp discrepancies between the target rate and money market rates.

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