Fear of illiquidity

There are thousands of fears, from arachnophobia to globophobia (fear of balloons) to zoophobia (fear of animals). What might the fear of market illiquidity look like?

Say that you are petrified that a day will come when markets will be too illiquid for you to convert your wealth into the things you need. There are two ways for you to buy complete peace of mind.

The first strategy involves selling everything you own now and buying checking deposits, the sine qua non liquid asset. Get rid of the house, the bonds, the stocks, the car, your couch, and your books. Use some of the proceeds to rent a house and a car, borrow books, and lease furniture. In renting back the stream of consumption benefits that you've just sold, your level of consumption stays constant. Negotiate the rental arrangements so that the lessor—the owner—cannot cancel them, and so that you can walk out of them at a moment's notice. Structuring things this way ensures that rental obligations in no way inhibit your ability to stay liquid. With your hoard of highly liquid deposits and array of rental agreements, you've secured a state of perfect liquidity. Relax. Breathe in. Enjoy your life.

The second way to perfectly hedge yourself from illiquidity risk would be to buy liquidity insurance on everything you own. For instance, an insurer would guarantee to purchase your house whenever you want to sell at the going market price. Same with your stocks, and bonds, your car and couches and your books. With every one of your possessions convertible into clean cold cash upon a moment's notice thanks to the insurer, you can once again relax, put your legs up, and lean back on the couch.

Since both strategies lead you to the same infinitely liquid final resting place, arbitrage dictates that the cost of pursuing these two strategies should be the same. Consider what would happen if the liquidity insurance route was cheaper. All those desiring a state of infinite liquidity would clamor to buy insurance, pushing the price of insurance higher until it was no longer the better option. If the checking deposit/rental route was cheaper, then everyone would sell all their deposits and rent stuff, pushing rental prices higher until it was no longer the more cost-efficient option.

Now I have no idea what liquidity insurance should actually cost. But consider this: liquidity option #1 is a *very* expensive strategy. To begin with, you'd be forgoing all the interest and dividends that you'd otherwise be earning on your bonds and stocks. Checking deposits, after all, offer no interest. Compounded over many years, that comes out to quite a bit of forfeited wealth. Second, you'd have to rent everything. And the sort of rent you'd have to negotiate would be costlier than normal rent. Last time I checked, most landlords require several months notice before a renter can be released from their rental obligation. But the rental agreements you have negotiated require the owner to accept a return of leased property whenever *you* want—not when they want. And that feature will be a costly one.

Since option #1 is so expensive, arbitrage requires that option #2 will be equally expensive. Let's break it out. Option #2, liquidity insurance, allows you to keep the existing flows of income from stocks and bonds as well as saving you from the obligation of paying high rent (you get to keep your house and all the other stuff). Not bad, right? Which means that in order for you to be indifferent between option #1 and #2, the cost of insurance must be really really high. If it wasn't, everyone would choose to go the insurance route.

So who cares ? After all, liquidity insurance doesn't exist, right? Wrong. Central banks are significant providers of liquidity insurance. They insure private banks against illiquidity by promising to purchase bank assets at going market prices whenever the bank requires it. This isn't full and complete liquidity insurance— there are a few assets that even a central bank won't touch—but it's close enough.

The upshot is that banks are well-protected from illiquidity. They get to keep all their interest-yielding assets and at the same time can rest easy knowing that the central bank insures that those assets will always be as good as cash. Consider what things would be like for private banks if the central bank were to get out of the liquidity insurance business. Now, the only way for bankers to replicate central bank-calibre liquidity protection would be for them to pursue option #1: sell their loan books and bond portfolios for 0%-yielding cash. But then they'd be foregoing huge amounts of income. They might not even be profitable.

With logic dictating that the cost of buying liquidity insurance needs to be pretty high, are modern central banks charging sufficiently stiff rates on liquidity insurance? I'm pretty sure they aren't. Regular insurers like lifecos require periodic premium payments, even if the event that said insurance covers hasn't occurred. But the last time I read a bank annual report, there was no line item for liquidity insurance premiums. It seems to me, and I could be wrong, that central banks are providing liquidity insurance without requiring any sort of quid pro quo. Feel free to correct me in the comments section.

Say that I'm right and that central banks are providing private banks with underpriced liquidity insurance. Central banks are ultimately owned by the taxpayer, which means that taxpayers are providing private banks with artificially cheap liquidity insurance. And that's not a fair burden to put on them. Nor is the underpricing of insurance a good strategy, since it results in all sorts of institutions getting insurance when they don't necessarily deserve it.

Does anyone know if central banks have any sort of rigorous model for determining the price they charge for liquidity insurance. Or are they just winging it? ... it sure seems like it to me.

Tweet

Subscribe to receive free email updates: