Liquidity in global markets

J. Caruana and L. Kodres

Financial Stability Review, 2008, issue 11, 65-74

Abstract: The latest episode of turbulence has been marked by an extended period of illiquidity in a large number of markets –ranging from traditionally highly liquid interbank money markets to the less-liquid structured credit markets. The event began with what was widely perceived as a credit deterioration in the US subprime mortgage market. However, this quickly raised uncertainty about the valuation of securities related to this market, thus affecting their liquidity. The rapidity with which this market illiquidity has been transmitted into funding illiquidity has been both striking and unprecedented. The event has raised questions about how market liquidity in a variety of instruments is determined in both primary and secondary markets and how mechanisms act to transmit illiquidity across markets during a period of stress. The article seeks to identify how standard concepts of liquidity can be applied to various types of markets across the globe with a view to interpreting how liquidity deteriorated so quickly. Several attributes of liquidity –types of market structures (including existence of formal intermediaries and trading venues), the construction of the instruments, and the types of investors– are used to guide the analysis. One feature that appears to be important for liquidity is the degree to which information about the risks underlying the financial instrument are well understood by both buyers and sellers. Another insight is that the expectations of market participants about liquidity and their ability to monitor it also have an impact on liquidity itself. These attributes suggest that the growth in securitization and complex structured credit products –new developments in the transfer of credit risk– may carry with them a predilection to adverse liquidity events that will require further examination. In light of the analysis, the article identifies ways of mitigating some of the problems that arose in this latest bout of illiquidity. Because liquidity is created and maintained by the market participants themselves, most of the room for improvement rests with the private sector. It is already clear that some market practices and policies will need to change and in this context some suggestions for enhancements to financial institutions’ liquidity risk management are outlined. However, given that both market and funding liquidity are intimately related to financial stability, a public good, there is also a potential role for the public sector. Hence, the tools used by central banks to maintain their role in effi cient monetary policy transmission together with financial stability will need to be reviewed.

Date: 2008
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Persistent link: https://EconPapers.repec.org/RePEc:bfr:fisrev:2008:11:9

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