Liquidity is the availability of money that can be put to immediate use. Put another way, liquidity is the balance sheet capacity to finance new projects or roll over existing debt.
Why does this matter to a pension manager like Tidepool?
It matters because any Funds offered in an investment lineup must be supported by a large underlying pool of available liquidity. Without a strong liquidity pool available to support an investment fund, demand is choked off and liquidity risk rises.
Liquidity can, and does, evaporate from the financial system from time to time — sometimes with little warning. When this happens, asset values drop precipitously and balance sheets sustain real damage at all levels of the economy. So, for pension holders and their managers, it is essential to understand and foresee liquidity risks as well as possible, to avoid the avalanche of falling asset prices during a major liquidity shortfall.
WHO CONTROLS LIQUIDITY?
A large amount of liquidity is controlled by central banks, such as the Federal Reserve, directly or indirectly. But at least half, if not more, of global liquidity is provided by global wholesale money markets, a loose combination of Sovereign Wealth Funds, pension reserves, development funds and foreign exchange reserves. These global wholesale money markets are independently managed and are not accountable to central banks or to regulatory bodies. The Federal Reserve can, and does, exert control over a certain amount of liquidity available to the financial system–but it has significantly less effect on the wholesale global money markets.
Global liquidity is gradually shifting east to the Asian economies–largely to China. This is because new investing opportunities are more pronounced in the emerging economies of the East, whereas investing opportunities in the West are significantly limited to roll-over of debt.
Data show that $7 of every $8 invested from money market funds is used for roll-over of old, existing debt. This is a staggering drag on financial growth.
THE VIX CARRY TRADE: LIQUIDITY TRANSMISSION
Liquidity–available money–is largely transmitted through the economy largely through the “VIX volatility carry trade,” a ubiquitous method of trading controlled by large institutional banks, as well as hedge fund shadow banks.
The VIX carry trade is a process of selling levered short-term VIX options that display relatively high implied volatility for a 21 to 35 day period, then buying back those options near the option expiration date, when realizied volatility has decreased because of the nearness of the expiration date. This is essentially a process of selling an asset at a high price, then buying it back at a low price–always a good strategy for making money.
Predictable functioning of a volatility carry trade depends on an environment of moderate volatility. Moderate volatility means option prices do not swing wildly from day to day.
Low volatility fails to generate enough movement to support a volatility trade. Conversely, high volatility puts option trades at risk of being wiped out too early by wild price swings that can force a buy back of the option before the expiration date when volatility (and therefore its price) is relatively too high for a profitable trade. This wipes out a carry trade strategy. So, like in the Goldilocks story, moderate volatility is “just right” to support a sustained carry trade.
An unacknowledged objective of Federal Reserve strategy is, we believe, maintaining a stable market environment to support carry trades. We argue that the Fed’s policy focus is market stability, far more than interest rates or employment. It follows that interest rate policies are implicitly designed to support stability and moderate volatility swings. Market stability–and hence volatility–can be maintained in high interest rate environments as well as low. Therefore, stable markets matter much more than the absolute level of interest rates–or employment rates. This is why we see market stability as a predictor of potential liquidity risk.
It may be but a slight exaggeration to say that we now live in a world largely supported by massive carry trades that sustains high asset prices–notably stock and real estate prices. These carry trades appear to be controlled by hedge fund subsidiaries of large US prime dealers: Goldman Sachs, JPMorgan and Morgan Stanley and the stock lending arm of these entities that may control collateral flows, EquiLend. These trades are leveraged OTC trades; opaque to the general market.
It can therefore be said that carry trades are the dominant mechanism by which liquidity (available money) is transmitted through the economy to the various profit centers that support the global economy.
HOW ARE LIQUIDITY POOLS ACCESSED?
Global wholesale liquidity pools are regularly accessed by private borrowers through both cleared (tri-party) and non-cleared (bilateral) repo trades, backed by collateral required by the lender. The non-cleared market means there is no intermediary facilitating the trade (such as in the tri-party cleared repo market). The market chosen by the repo traders is typically a function of the quality of collateral pledged for the repo loan.
High-quality collateral (Treasuries and IG corporate bonds) is traded in the cleared tri-party markets that make data available to regulators. This process greatly mitigates risk of repo trades in the cleared market.
Low-quality, risky collateral (securitized products, derivatives, long-duration real estate securities and long collateral chains) are offered up as collateral in non-cleared bilateral repo trades. This is the risky collateral that quickly becomes suspect in a liquidity crisis.
HOW IS LIQUIDITY RISK MANIFEST?
Liquidity risk (the unavailability of money needed to to finance new projects or roll over existing debt) shows up when the structure of the carry trade is disrupted by significant changes in volatility (see discussion above).
But all carry trades also depend on relatively low borrowing costs in Eurodollar and other global money markets.
Changes in capital flows or collateral availability that increase borrowing costs mean that the money markets, particularly non-cleared repo markets, can become temporarily unavailable as a source of funds for the carry trade. This last happened in Sept. 2019 when repo rates spiked from 2% to 10%. And since the carry trade dominates all financial transactions in major markets, and repo is the primary source of money for the carry trade, a disruption of money markets directly causes liquidity crises–and asset value crashes caused by lack of liquidity.
Liquidity is an expression of the strength of balance sheets. If every participant in repo maintained an unleveraged, strong balance sheet, the ebbs and flows of liquidity would go mostly unnoticed. But alas, that is not the reality of our financial world. It appears that every major financial institution is actually leveraged to the maximum amout available, to increase profits. So balance sheet strength is a great theory–but not an observable reality.
CAN LIQUIDITY BE CREATED OUT OF THIN AIR?
No. In our view, unlimited liquidity cannot be created out of thin air; at least not liquidity that supports economic growth. Liquidity for economic growth (as opposed to rolling over old debts) depends on creation of new credit. In this regard, our research shows that increased borrowing to support growth must organically originate from the real economy, not from a central bank. This is why we see liquidity created by the Federal Reserve get “stuck” in the balance sheets of large banks, unable to “trickle down” to the real economy.
For example, New credit, such as the massive amount of home loan credit from 2001 to 2008, fueled an explosion in liquidity, leveraged by credit default swaps and other credit derivatives and securitizations. These new derivatives and security instruments, built on the back of millions of mortgage borrowers, provided the liquidity of new credit that is essential to expand the base of liquid money. But when the new credit instruments unraveled and were no longer good collateral, liquidity in the financial system evaporated and the entire system became in immediate jeopardy.
Old, recycled credit–such as that remaining from the 2007-08 global financial crisis, is insufficient to support expanding liquidity. These old credit obligations remain a drag on real economic growth. Old credit obligations should (in the opinion of many) be revalued to zero, to clear the system of collateral and allow the economy to reset and restart. But owners of this worthless collateral mostly refuse to let go of the hope of some day recapturing value, so a large percentage of this worthless collateral continues to circulate in the system, pretending to offer collateral value, but unable to do so. The larger this percentage of re-hypothecated collateral becomes, the more it squeezes out strong collateral, dragging down the entire financial system with it.
Liquidity flows seem to observe Gresham’s Law that overvalued (bad) money drives undervalued (good) money out of circulation and into hoards. And this is the real problem with recycled collateral and loans that are rolled over ad infinitum. The old, worthless (bad) money remaining in the system chokes out any new (good) money, putting a stranglehold on growth.
In our current global economy (circa 2023) it is estimated that $7 out of every $8 invested is used to roll old debts. This leaves only 1/8 investment dollars available for new investment commitments; not enough to sustain investment growth. As this ratio rises, we may dangerously approach the hoarding dangers predicted by Gresham’s law.
We at Tidepool are working hard to identify early warning signals of liquidity crises–primarily disruptions in the carry trade and material changes in asset flows. We will periodically post updated assessments on our Insights page, for the benefit of our Plan Participants.