This day in history - November 18, 2013: "Liquidity risk affects asset prices" says Cass Business School - FinanceFeeds

This day in history – November 18, 2013: “Liquidity risk affects asset prices” says Cass Business School

Three years ago today, the OTC derivatives world was a very different place, especially where access to liquidity is concerned. We take a look back to this day in November 2013 when Cass Business School’s Professor of Finance Giovanni Cespa issued his findings on co-movements in liquidity

During the course of this year, a great deal of emphasis has been placed on how liquidity should be sourced, and how the restrictions that have been placed on the OTC derivatives sector by Tier 1 banks having taken an ultra-conservative approach to extending credit can be mitigated in order to maintain good risk management yet provide best access to live pricing.

Whilst this particular dynamic is relatively new, spearheaded by Citigroup, the world’s largest FX interbank dealer with 16.1% of the entire global market, having stated that it forecasts a 56% default ratio for OTC derivatives when extending credit.

The resultant surge in demand for non-bank aggregated liquidity from electronic communications networks (ECN) and prime brokerages, as well as the adoption of ‘ecosystem’ models by integration and bride providers is relatively recent, however on this day in 2013, London’s Cass Business School concluded a series of research pieces on the matter of how the liquidity of one asset class can affect that of another.

Giovanni Cespa, Professor of Finance at Cass Business School is an alum of the University of Bareclona, from which he obtained a PhD in Economics.

In our industry, there are very few academics who have practical experience or the required business acumen to be able to make critical decisions whilst understanding the full structural requirements of the electronic trading industry, however research on aspects such as the co-movements in liquidity and price observability that Professor Cespa studied in detail are very useful indeed.

Professor Cespa concluded on November 18, 2013 that there had become a growing consensus among financial economists over the importance of market frictions to explain asset pricing anomalies. According to this view, frictions pose an impediment to the working of textbook arbitrageurs in their attempt to exploit price discrepancies, thereby preventing asset prices from falling in line with fundamental values. A relevant role in this respect is played by liquidity.

He continued to observe that the liquidity of an asset captures the ease with which the asset can be traded.

A number of factors contribute to an asset’s liquidity: the existence of transactions costs (e.g., taxes or brokerage fees), by imposing an exogenous outlay on the negotiating parties, lowers the gains from trade, thereby augmenting the asset illiquidity.

Similarly, found Professor Cespa, the potential difficulty to readily find a counterparty, by increasing the uncertainty over the successful completion of a trade, also weigh negatively on an asset liquidity.

Finally, the illiquidity of an asset is also heightened by the existence of asymmetric information in the market: this is because the risk of facing agents holding better information reduces less informed parties’ willingness to take part in a transaction.

Quite interestingly, Professor Cespa stated that as a consequence of different co-movements, liquidity risk (i.e., the risk that asset liquidity worsens when investors need to trade) affects asset prices. Intuitively, given that the liquidities of different assets are related, the risk implied by their random variation cannot be completely diversified away in investors’ portfolios, and thus becomes a systematic factor that commands a compensation in terms of expected return. In view of the recent events related to the subprime crisis, extreme manifestations of the impact of liquidity risk on asset prices seem to abound at different frequencies.

On May 6, 2010 several US-based equities and equity products (ETFs and equity indices in securities and cash markets) experienced an impressive price decline followed by a rapid recovery, giving raise to the so-called “Flash Crash.” In the event more than 20,000 trades across over 300 securities were executed at prices more than 60% away from the values they had moments before. In many markets, liquidity eroded very rapidly, and almost evaporated.

At a theoretical level, however, the causes of liquidity risk are not well understood. One possibility is that liquidity co-movements at a given point in time arise because of “demand-side” effects. For example, because of the correlated trading activity of different types of investors. An alternative possibility is instead that the trading decisions of liquidity suppliers are correlated. In this respect, it has been posited that aggregate liquidity dry-ups may be the upshot of market-wide tightening of capital constraints for liquidity suppliers.

Ironically, Professor Cesca highlights the sub-prime lending crisis during the late Millennial years as an example of bank liquidity constraint, however the banks have not learned from this and in some regions (not North America where the criteria is now very strict) the retail banks are now lending money to retail customers on a 95% loan to value basis, which is very high risk business. The sale of defaulted mortgages to sub prime lenders by major banks at the end of the last decade was one of the factors which created the financial crisis’ major facet – the credit crunch, yet the very same banks are now reluctant to extend credit to OTC derivatives dealers even if they have a capital base of over $50 million.

Logic is a strange thing indeed….

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