Lesson 7 of 25 · 7 min

Market liquidity and funding liquidity, distinguished

One asks whether an asset can be sold, the other whether cash can be raised against it, and either can fail alone.

Liquidity names two different properties and the single word does not distinguish them, which is why discussions of it so often produce confident disagreement.

Market liquidity is a property of an asset and its market: how much of it can be converted to cash, how quickly, and how close to the quoted price. Funding liquidity is a property of a balance sheet: whether cash can be obtained against that asset, and whether borrowing already secured on it can be rolled when it matures. The first is about buyers. The second is about lenders.

The four states, and which ones actually occur:

Both available — the ordinary condition, and the one every plan is written in.
Market liquidity without funding liquidity — an asset that trades perfectly well but has been moved to a zero row, or a facility with no undrawn capacity left.
Funding liquidity without market liquidity — a lender willing to advance against something that cannot be sold quickly. Common just before a stress and rarely during one.
Neither — the state the whole of this track is about, because the two fail from the same cause.

Price them against each other on a pledged portfolio. Raising $250,000 by selling costs the price impact of the sale, illustratively 0.35 percent or $875, and the collateral is gone permanently. Raising it by drawing costs interest: 7.4 percent for 60 days on an Act/360 basis is $250,000 times 0.074 times 60 divided by 360, or $3,083.33, and the collateral stays. In a stressed week the impact figure becomes 2.12 percent, or $5,300, and the drawing route may not exist at all because capacity was revised the previous night. Both prices moved, in the same week, from the same cause.

Key terms

Market liquidity: How much of an asset can be sold, how fast, and how near the quoted price. A property of the asset's market on the day.
Funding liquidity: Whether cash can be raised against an asset rather than by selling it. A property of a lender's willingness, not of the asset.
Roll: Replacing maturing borrowing with new borrowing on the same collateral. A failure to roll turns a funding problem into a forced sale.

Worked example

Two routes to $250,000, priced in calm and in stress

Illustrative figures. A pledged portfolio, a 60-day cash requirement of $250,000, a drawing rate of 7.4 percent on an Act/360 basis.

Cost of selling, calm market: $875
Cost of drawing for 60 days: $3,083.33
Cost of selling, stressed market: $5,300
Availability of the drawing route in stress: Subject to capacity
What the collateral does under each: Gone, or retained

In calm conditions the two routes differ by a factor of three and both exist. In stress one is six times its old price and the other may not be there.

Check yourself

You need $180,000 for 45 days. Selling carries an estimated price impact of 0.48 percent; drawing costs 8.1 percent on an Act/360 basis. What does each cost, and what changes about the comparison in a stressed week?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.