Lesson 9 of 25 · 7 min

Why liquidity is abundant until the moment it is needed

It is supplied by people whose willingness to supply it falls with the same thing that raises everybody's need for it.

Liquidity is not a property an asset carries around with it. It is a service, provided by intermediaries who decide each morning how much of it to offer, and the decision is made on the day rather than promised in advance.

The provider's arithmetic is simple and it is the whole story. Holding inventory between a seller and an eventual buyer exposes the provider to price moves, and that exposure is roughly the size of the inventory multiplied by the asset's volatility. The provider works to a fixed budget of risk. When volatility rises, the same inventory consumes more of the budget, so the inventory is cut. Nobody panicked and no view was formed; one input changed and the same rule produced a smaller number.

That produces the negative correlation that defines the subject. The events that make you want cash — a sharp decline, a shortfall, a failure to roll — are the events that raise volatility, and volatility is what shrinks the supply. Demand and supply move in opposite directions from a single cause. Measured abundance during a calm quarter therefore says very little about availability during the quarter you would need it, because the two readings are taken from different regimes.

Land it on a pledged portfolio and add the part most plans omit. Raising $462,000 costs $1,293.60 at a calm price impact of 0.28 percent and $13,398 at a stressed 2.9 percent, which is 10.4 times as much. And the plan is not yours alone: if eight accounts on the same lender's book hold the same name and reach the same conclusion in the same week, the combined $3,696,000 is 194.5 percent of a normal day's volume in it.

Every liquidity plan is written as though it will be the only one executed. In the week it is needed it is one of many, and that crowding is what makes the week.

Key terms

Liquidity provision: The service of standing between a seller and an eventual buyer by holding inventory. Offered at a price that is reset daily.
Risk budget: A fixed amount of price exposure an intermediary is willing to carry. Held constant while volatility moves, which forces the inventory to move.
Crowding: Many holders reaching the same conclusion about the same asset at the same time, which converts an individually small sale into a collectively large one.

Worked example

The same plan, priced in two regimes

Illustrative figures. A plan to raise $462,000 from one holding whose average daily volume is $1,900,000, held by eight accounts on the same lender's book.

Cost at a calm price impact of 0.28 percent: $1,293.60
Cost at a stressed price impact of 2.9 percent: $13,398
Ratio between the two: 10.4 times
Combined sale if all eight act in the same week: $3,696,000
That total against one day's volume: 194.5%

The plan was costed at one twentieth of a day's volume and one accountholder. It executes at nearly two days of volume and eight.

Check yourself

Eleven accounts each hold $340,000 of the same security, whose average daily volume is $2,600,000. Price impact is 0.31 percent in calm conditions and 3.4 percent in stressed ones. What does one account's sale cost in each regime, and what is the combined position?

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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.