The credit crisis has demonstrated the need for a new generation of market-based liquidity measures that are both dynamic and scalable. But while newly-designed liquidity regimes for financial institutions resulted in calls to increase both the amount and the quality of their liquid assets, less attention was assigned to the question of how to ensure that these “liquid” assets are indeed highly liquid — a challenge, especially for those instruments (like bonds, derivatives, loans, asset-backed securities, etc.) that trade in OTC markets.
Liquidity is notoriously hard to measure. While some market participants might advocate using observed trading activity to quantify prospective liquidity, examining transactional volumes in isolation is not sufficient, particularly for OTC traded products, most of which do not trade on a regular basis. Gauging trading activity will only cover a limited part of the universe of tradable products, trade data is not always freely available, and turnover for a product could suddenly dry up.
In reality, the fact that a security has not traded in the recent past is not proof in itself that it is illiquid.
While factors such as market structure, diversification of the investor base and issuance size are some of the underlying drivers of the liquidity of financial products, trying to measure them is also unlikely to deliver meaningful results. This is because one will never be able to define a complete list of all factors that can impact liquidity: many are either unobservable or hard to quantify. Moreover, the relative importance of the different factors is unclear.
Focusing On Prospective Liquidity
From a risk management perspective, the liquidity of a financial product is important because it affects the holder’s prospective ability to sell the position close to the current market price within a certain time horizon. This ability to sell can be described as the product’s “prospective liquidity.”
The best way to gauge liquidity is by focusing on the indicators of liquidity instead of the drivers outlined above, as they are generally both observable and quantifiable, and also permit a certain level of comparability both across asset classes and individual assets.