Preparing for Drought While Still Awash with Liquidity

Abstract

This research commentary discusses liquidity in the context of corporate cash portfolios, coming challenges in the post-crisis era, why liquidity reversal may be a systemic concern, and how investors should prepare for the new liquidity equilibrium in a normalized interest rate environment. Our suggestions for corporate cash professionals include the following:

1. Review and Revise Liquid Portfolio Investment Policy
2. Build a Liquidity-based Credit Approved List
3. Retool Portfolio Holdings Transparency
4. Add Trading Counterparties
5. Embrace Electronic Trading
6. Turn Challenges Into Opportunities

Introduction

“Water, water, everywhere, and all the boards did shrink; Water, water, everywhere, nor any drop to drink.”
Dramatic as it sounds, this Ancient Mariner’s Rhyme may somewhat foreshadow the future liquidity state of our financial markets. Unconventional central bank policies in the wake of the 2007-2008 financial crisis have pumped tremendous excess liquidity into the financial system. Meanwhile, scars from the crisis and ensuing financial regulations resulted in the disappearance of many financial intermediaries and reduced capacity at the ones that remain. As Federal Reserve officials prepare to conclude asset purchases next month, the question of how to remove excess liquidity from the markets without causing systemic consequences should be a major topic of interest to all participants.
In this research commentary, we will discuss liquidity in the context of corporate cash portfolios, the new challenges to liquidity in the post-crisis era, why liquidity reversal may be a systemic concern, and how corporate treasury professionals can be better prepared for the new liquidity equilibrium in a normalized interest rate environment.
Liquidity and Corporate Treasury Management
The simplest definition of liquidity is the ability to convert something into cash quickly. Most people agree that liquidity is essential to firms, markets, and financial assets, yet the term often means different things to different people. For example, ‘market liquidity’ measures how quickly an asset can be bought or sold without an impact on its current price. The speed of trade execution and the bid-ask spread are also important measures of liquidity. In addition, daily trading volume, average trade size, the number of market makers, and the number of potential market participants are all relevant measures of liquidity.
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