Contemporary Finance

12Liquidity

Why should anyone outside a lunatic asylum wish to use money as a store of wealth?

Keynes, “The General Theory of Employment”¹

12.1 Funding and Market Liquidity Risk

The term “liquidity” has several closely related¹ meanings. Funding, or balance-sheet, liquidity describes the ability to maintain debt-financed asset positions and meet immediate cash obligations. A market participant is liquid in this sense. Market, transactions, or liquidity describes a market participant’s ability to buy or sell an asset without influencing prices adversely, pushing them up if buying or down if selling. A market or a financial instrument is liquid in this sense.

Liquidity is also used to describe a stock of assets available to carry out exchanges. The different meanings of liquidity are linked by different ways to use an asset to raise funds. An asset can function as money directly, as a means of payment, or indirectly because it can be readily sold to obtain money or used as collateral to borrow money. Funding liquidity reflects the ability to borrow against an asset, and market liquidity is defined by the ease with which an asset can be exchanged for money.

Both are rooted in two transformations that lead to the creation of assets that resemble or can be used as money, carried out on financial intermediaries’ balance sheets, historically, primarily by banks. Intermediaries effect a maturity, duration transformation of a longer- into a shorter-term asset by borrowing short-term ...