Liquidity is a strange phenomenon – but ignoring it is dangerous. In the commercial world liquidity describes the ability of a business to meet its short-term obligations – usually measured in months. In the financial markets, liquidity indicates whether or not a security can be traded (or liquidated) immediately – usually measured in hours/days. However, no matter what way liquidity is parsed, it relates to an ease of exchange – usually measured in cash.
The reliance on cash is peculiar given how we all know that milk is the fastest liquid on the planet – it’s pasteurised before you see it!
Even in our personal lives, liquidity is important. Living in a large, expensive house is not practical unless you have sufficient income for its upkeep. Travelling to the supermarket in a fancy car is not rational unless you have funds to pay for the groceries.
So, liquidity is that understandable ability to trade with others in a way that is an acceptable substitution. For example, think of the services that pawnbrokers provide. They swap our items of value for cash, which is an acceptable means of exchange. The wonders of liquidity are all pervasive and yet it drops down the list of importance in many unguarded ways.
In recent months, financial regulators have published 3 papers on the significance of liquidity:- one on liquidity mismatches in Irish property funds; one highlighting liquidity risks for European fund managers; and a third one providing regulatory guidance for alternative investment fund managers. One would imagine that past experiences, where lack of liquidity was shown as a key failure in assessing point-in-time investment valuations, would act as a clear warning to fund managers on the perils of underestimating liquidity. Alas, apparently not.
It is disturbing to find that Irish and European regulators have found it necessary to issue formal guidance on a subject matter that proves amazingly obvious in hindsight. How many more investment fund calamities must we suffer before liquidity is rightly seen as a number-one feature in every investment proposal?
The Irish regulator has warned of unrealistic valuations being presented to consumers in property funds; where numerous redemption requests force the fund managers to reappraise their positions. If everybody heads for the exits at once, the ability of the fund manager to liquidate part or all of the fund is improbable. Property takes time to shift (an average of 180-210 days in normal economic circumstances and 420 days in stressed economic conditions). The regulator estimates that only 17% of property funds hold assets that can avoid the liquidity trap; and, therefore, questions the ability of the other 83% to provide interim valuations to investors – classifying them as unreliable and/or significantly misleading.
Unbelievably, there is no European-wide macro-prudential framework covering liquidity shortcomings. This is surely an urgent concern. Without consensus and agreement on the basics, the lessons of the past will not be heeded. Consumers are advised to examine the liquidity aspects of any proposed investment; bearing in mind that their personal circumstances may change mid-investment.
