As we’ve seen in previous articles, liquidity is ‘good’ only if your need for it isn’t shared by most other market participants at the same time. If everyone else wants to liquidate at the same time you do, liquidity can be a very bad thing. But if liquidity isn’t always good, how did we get to this point where nearly everyone believes the most prudent strategy is always to stay liquid? The answer is that we’ve been conditioned to favour liquidity, thanks to a bunch of systematised biases and the result has been a widespread case of what I call liquidity bias.
For starters, consider the concept of T+2. Set by the SEC, T+2 is the requirement that stock-market trades settle – and that you get your money out – two business days after trade date T. (The rule has changed over time from T+7, moving most recently to T+2 in September 2017.) The point of requiring trades to settle in two business days is to keep markets moving swiftly and to reduce the likelihood of default. Since liquidity is the ease with which you can buy and sell the assets you want in the quantity you want, liquidity is effectively mandated by T+2 for most broker-dealer security transactions.
“Wall Street is like a shark that has to swim to breathe and liquidity is what keeps its heart pumping”
The notion that you should be able to get your money out in a couple of days has become a kind of creed for investors of pretty much every stripe and it’s the accepted guideline for institutional investors. Thus, T+2 is one important source of liquidity bias – but it isn’t the only one.
Liquidity is essential to the basic mechanics of the financial industry. Brokerage commissions are generated on the basis of liquidity: a trader makes money when something is bought or sold, not when it’s held. Wall Street is like a shark that has to swim to breathe and liquidity is what keeps its heart pumping.
