The State of Liquidity

May 23, 2016

So how much liquidity do you need? I ask this question because the global market’s definition of liquidity has been changing dramatically. This change has been particularly troubling over the last ten years.

Liquidity is defined as the ability to convert an asset to cash, which is then available for new opportunities in the market, or to take care of the cash flow needs of a company or family. One of the most critical functions businesses perform is managing cash flow and this starts with the assessment of when money will come in and when obligations are due.  In today’s environment every investor should understand the state of liquidity in the marketplace and make certain that they are planning accordingly. Market liquidity is not what it used to be.

For years the most liquid of all securities were U.S. treasuries. The Federal Reserve, recognizing the need for a liquid treasury market, long ago established a group of firms designated as “primary dealers”. Their role was to provide a market and therefore liquidity, for any seller of a U.S. government-issued security. Regardless of the amount or size of the trade, these dealers were required to provide liquidity to sellers. In the last forty years, the number of primary dealers has fallen from thirty-six to twenty-three. Of the remaining twenty-three, only eight are U.S. firms, so currently the U.S. has placed a key dependence on fifteen foreign firms to provide the liquidity for our government debt. With fewer firms providing the liquidity needed for the largest bond market in the world, it should not surprise you that liquidity is more limited.

We saw recently that when the oil market came under stress, the liquidity of the debt of pipeline companies and oil and gas exploration firms went pretty much to zero. The old fallback of being able to get out of a position at will no longer applies. Dealers and fund managers have been forced to rethink the definition of liquidity. Prudential’s head of fixed income trading commented this week that investors cannot count on the liquidity of the past and that all investors should think about their portfolios with a longer-term view.

It can be almost painful for investors to hold cash these days. In most markets, cash is earning nothing and in some markets, yields are negative. Currently we are in an environment where the cost of liquidity has risen. Investors must weigh the desire to earn something on their money against the risk of not being able to raise cash due to the lack of liquidity. This new worry will require investors to look at cash management with the same attentive eye as they look at the rest of their financial world. In these times, we should make certain that in addition to retirement planning and estate planning, cash management planning is central to the management of your wealth.

Carl Gambrell