A few years ago a bank explained that it would make a market for $5m with a two point bid offer spread for a CDO should the client so wish. This was sold to the client as a demonstration of commitment and liquidity.
Liquidity is important for a number of reasons.
It reduces transaction costs, provides continuity and minimises the possibility of discontinuous market pricing. The effects of which can be unpredictable.
What constitutes a liquid market is hard to define. But from my experience it requires infrastructure, traders, customers, brokers and confidence.
When this is working well a large number of parties collectively buy and sell. Both large and small amounts can be shifted without significant price movements. It’s helpful to everyone.
Recent market reforms correctly clamp down on market abuse. But whether infrastructure reform is entirely necessary remains to be seen. Clearing may lead to the mother of all risks if it fails.
Likewise any reform that alters the ecosystem of players may well lead to some unintended consequences that we only find out about in the years to come. In this respect reduced trading inventories must surely increase risk.
As the CDO investor found out when fear overcame greed prices fell 20%.
Being able to sell $5m was not remotely beneficial particularly when the entire position was ten times larger.
Liquidity never has been a guarantee of safety.
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