Liquidity Dis-Premium!

One of the blogs I have started following is of Pablo Triana. He's a Finance Professor at IE (Spain) - http://www.ie.edu/

One of the bloggers on Wilmott, Pablo writes elegantly. Following is an article he recently wrote on the idea of Liquidity Dis-premium. As wacky as it sounds, the argument has some weight. Normally you assume that a liquid asset would always command premium over an illiquid one because of the ease of conversion into cash. But, Pablo has another take on this.

It is conventionally assumed that many "normal" assets (equities, many commodities) enjoy a built-in liquidity premium: they are worth dearer than otherwise because of the possibilities they offer for quick and easy trading (ie, you can get rid of your position very conveniently and with transparent pricing). But in a world where many players (savvy and un-savvy alike) hold very complex stuff, and where things like staid boring equities become today´s treasury bonds, cushions in case the complex stuff turns funny, or necessary as collateral with which to deal in complex stuff, or required to convince investors that you don´t just deal in mega-esoteric things, the liquidity premium could actually transform into a dis-premium (that is, a reason for a lower, not higher, valuation). Why? Simple. When complex-stuff markets go awry (like, well, now) the mark-to-market of the complex positions goes south or actually dissapears into nothingness, requiring punters to raise cash with which to meet margin calls, satisfy redemptions, and endow their positions with something actually valuable. What do they sell? What they can, which is of course their most liquid holdings. In the midst of a liquidity gold-rush, it is hard to dispose of iliquid things. So what happens to the prices of the liquid stuff that all those iliquid stuff-holding large players are dumping? They go down and become very volatile. The liquid stuff (along with those who invested in it) is paying the price for being so liquid at a time when non-liquid investments have become extremely voguish and prevalent. A purveyor of stocks may explain to their prospective clients that one of the things that justifies the asset´s dearness is its high liquidity. If you don´t like it anymore or need some money to send your kids to college, getting rid of the asset is as easy and transparent as 1-2-3. Isn´t that a wonderful property? Something worth paying for?. After these weeks' troubles many clients may start demanding a substantial discount simply on account of equities' too-deep-for-their-own-good liquidity.

Rritu