In Taxonomy of liquidity I I found that the distinction between market-based lending and bank lending could be clearly drawn only if the term “market-based lending” was used to refer strictly to traditional capital markets, that is, to the stock and bond markets, because money markets, repo markets, derivatives markets, etc. are all very dependent on explicit and implicit commercial bank guarantees. Here I want to address a different issue: the distinction between price stable liquidity and price disclosing liquidity.
Price disclosing liquidity is fairly intuitive. It is associated with the market liquidity that is available on stock markets or long term bond markets. Even though we consider Treasury bonds or Apple stock to be extremely liquid assets, we also understand that the prices of these assets are not stable, as any intraday chart of their prices will show. Stock and bond markets are designed to give asset holders a reliable venue in which to sell, while at the same time allowing prices to move to reflect what may be very short-term shifts in supply and demand.
Money market liquidity is different from this description of capital market liquidity. Money markets are markets where people who have cash that they will need in the near future try to earn a little interest. For this reason, money market investors are notoriously averse to sustaining capital losses (Stigum and Crescenzi 2007 p. 479). Furthermore, money market instruments are by definition short-term. Thus, unlike capital market issues, every issuer on the money market is more or less continuously raising funds. For this reason, when money market investors are worried that they may incur a loss, they don’t even need to sell their holdings to cause problems for the issuer; all they need to do is to refuse to invest in the new issues and the money market will be disrupted. In addition, because money market investors expect to need the money in the near future and are thus risk-averse, many of them avoid money market instruments that have any aura of credit risk.
An example of how money market investors react to losses is the behavior of prime money market fund investors in September 2008 after one prime money market fund, the Reserve Fund, announced that it would incur a small loss. The panic was so severe that the Federal Reserve, the FDIC, and Department of Treasury all established programs to support money market funds and the commercial paper in which they invested.
Thus, it is the nature of money markets that they are expected to provide price stable liquidity (cf. Holmstrom 2015). This form of liquidity is completely different from the liquidity provided by the stock market where losses are expected on a regular basis.
One of the reasons that banks play such an important role in money markets is that bank liabilities are promises to make payment at par. Banks offer price stable liquidity. Not only are banks generally managed so that they can offer price stable liquidity, but the banking system itself – and in particular the structural support provided by the central bank – is designed to protect the system of price stable liquidity. Indeed, it is because price stable liquidity is integral to the business of banking that credit rating agencies generally demand that money market instruments receive liquidity and credit support from a bank in order to qualify for the highest credit rating.
In my previous post I explained that a discount market is an unusual kind of market, because each seller is required to endorse the bill when it is sold and thereby to guarantee payment on the bill in case of default. The importance of price stable liquidity on the money market explains this requirement, and explains the essential difference between the London Discount Market and the London Stock Exchange in the 19th century. When every seller has to guarantee the value of the bill, the incentive structure of the discount market is such that only high quality debt trades, and with every trade the credit quality of the debt increases. This is clearly a means of supporting the price stability of the instruments that trade on the discount market. On the stock exchange, there was no such requirement, because it would have obviated the purpose of the sale.
Why is price stable liquidity so important on the money market? When short term instruments can’t be relied on to hold their value, the public starts to look for better places to put their money, and there are enough reasonable somewhat risky alternatives, including other currencies, that the monetary system will break down if it doesn’t offer enough stability. For a money market to survive over the long term it needs to be in the top of its class in terms of stability.
In short, there’s another aspect of liquidity to add to our taxonomy. Capital markets offer price disclosing liquidity, whereas banks and discount markets offer price stable liquidity. More generally, money markets need to offer price stable liquidity or they will be subject to panics and may be at risk of collapse.