Liquidity in normal circumstances and in stressed ones are at the core of the Money Market Fund Regulation. How much of the portfolio can be released to meet redemption requests? That is the central question.
When initial apprehension sets in, the first phenomenon is a run on the Fund. That would be quite similar to a run on a bank. These “runs” can become full-fledged routs leading to contagion. Regulation has in many ways, across sectors, moved away from simply preventing failure at one institution to preventing the spread of that failure across institutions, sectors and on to the economy as a whole.
There are two types of liquidity questions when it comes to meeting redemption obligations. One is the question of liquidity in the Fund’s portfolio. The other question of liquidity is in access to markets to access funds to meet redemption needs.
This article is about liquidity in the markets to be able to access it.
In the banking sector, under the Basel paradigm, liquidity is analysed in terms of the availability of cash in the system. Is there enough to meet the immediate obligations? In stress testing the question is re-framed to ask: how will the bank be able to cope with obligations if the money market were closed for 30 days?
Why 30 days?
Prior to the Global Financial Crisis of 2008/09, the closure of money markets itself was a Black Swan event: rare enough to count as a stress. Since during that crisis, there were periods of 15 days of unwillingness of banks to deal with each other, any kind of closure up to 15 days is completely conceivable.
So, the definition of stress moves to a 30-day closure.
In the MMFR, the definition of liquidity in the market for the purpose of stress testing is a classic ‘markets’ definition. Are there enough buyers and sellers in the market? A market is deep and liquid if there are enough buyers, so that no one participant can dictate terms. And conversely, are there enough sellers, so that no one participant can dictate terms to buyers?
If the market is indeed liquid, that will be seen in the Bid-Ask spread. The most liquid market is the one in which the spread is exactly one tick: the amount by which the market mandates prices to move, at a minimum – and not lesser than that. To be clear, the tick might be 0.0001 cents so that no one may quote 0.000075 cents.
Back to the MMFR formulation of the liquidity stress test. It takes the link between liquidity and spread and flips it: if the spread is wide, it means the liquidity is low. Extending that, if the spread had been narrow and has now started to widen, it means liquidity is dropping. How far can it drop? How wide can the spread be or become?
A sufficiently wide spread is stress. Therefore the expectation that the bids would have fallen substantially. And at that low bid, how much of your assets are realizable?
More on this when the guideline is finally released. But without a doubt, liquidity and its interplay with the mechanics of disposing assets is a fascinating study.
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