The paradox of liquidity

It is a truism that ultimately businesses (and even governments)  fail because they lose the ability to meet their obligations when due; which in reality means that they run out of cash or the equivalent means of settling their debts promptly. Financial history is littered with examples of such events too numerous to mention; and such occurrences are an inevitable consequence of the capitalist system, as businesses that once prospered fail.

However, that same truism masks a number of paradoxes that bear further examination in an environment in which central bank actions have supposedly created a world “awash” in liquidity; driven down returns on cash and debt securities; and created the feverish and inevitable “search for yield”. We are sure that such issues keep many a thoughtful CFO and Treasurer awake at nights. And, of course, financial alchemy is beginning to become visible again: RIP sub-prime mortgages and auction-rate securities; hail to sub-prime auto securitizations and to high-yield and leveraged loan ETFs!

So, what are some of these paradoxes or misconceptions? Firstly, just because an asset is publicly-traded and can be bought and sold at any time during market hours, does not mean that it is really liquid. True liquidity would mean that an investor could sell his or her entire position instantly at a price that reflected at least  the valuation placed on it in the relevant account. Obviously, size matters; as, with few if any exceptions, no market is able to absorb an immediate sale by its largest investor without the price moving. Secondly,  the direction of the market at the time of a proposed sale is also crucial: It is much easier to sell into a rising market, where buyers outnumber sellers. Thirdly, sometimes the market literally panics and seizes, so that there is no price discovery and so no ability to trade at all- events during 2008 and early 2009 provide ample evidence of that.

It seems to be regularly forgotten (institutional memory being increasingly rare) that the liquidity of a particular structure (being able to sell in size without an adverse movement in the price) cannot really exceed that of its underlying assets. Thus, we would argue that many a so-called “liquidity alternative” (say, a Money Market Fund, or leveraged loan ETF)  is exactly that; it is an alternative to truly liquid assets and will almost certainly not meet the test when most needed, because its structure is not really designed to provide liquidity, but rather to provide the chimaera or the illusion for as long as normality prevails. In moments of market stress it can and will fail- and too many participants will claim that this was “unexpected”, or “unprecedented”. It isn’t and it won’t be!

In the world of (re)insurance investment management, addressing the core premise and promise of the business model, being as certain as one can be of having sufficient liquidity available to pay any conceivable valid claim in a timely manner, is fundamental. Without it, there is no business. So, the current environment creates real challenges in terms of actually being able to generate adequate positive risk- and capital-adjusted returns on investment, with minimal balance sheet volatility, while generating the premium income streams that underpin not only viability and business growth, but also support the valuation of the business.

At Awbury, we have some thoughts and suggestions on that.  Give us a call!

– The Awbury Team

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