Leverage and liquidity

Liquidity is the ease with which the trade occurs in financial markets without significant price impact in the market. In other words, liquidity is “the ease and speed with which agents can convert assets into purchasing power at agreed prices”.⁶² Liquidity is central to every financial system and one of the crucial aims of a sound financial policy is to secure liquidity for the entire financial system.

The absence of liquidity, i.e., illiquidity can produce negative externalities which would imperil the well functioning of the real economy. Since the level of capital has a positive relationship with the level of production (economic output), any changes in the level of capital can have real

60 Ang, Gorovyy and van Inwegen, Hedge Fund Leverage, pp. 104-105.

61 Daníelsson, Taylor and Zigrand, Highwaymen or Heroes: Should Hedge Funds be Regulated? A Survey, 522-543.

62 Levine, Financial Development and Economic Growth: Views and Agenda, 688-726.

effects on the real economy. In addition, liquidity affects the cost of capital; thereby it indirectly affects the real economy. Therefore, liquidity can cause a shift in the production possibilities frontier of the real economy by affecting the level of input and output of the economy. Since illiquidity externality can produce “a shift in the functions relating quantities of resources as independent variables and output quantities or utility levels of consumers as dependent variables”,⁶³ it is a technological or true rather than a pecuniary externality. Needless to say, technological externalities are the ones that economic theory is much concerned with.

The economic and finance theory explains how the problems of liquidity can lead to the failure of solvent, but illiquid financial institutions, how liquidity crises can be contagious, and how easily they evolve into systemic crises. For example, suppose a financial institution (a hedge fund) is affected by an external shock which can cause asset price declines. Due to the mark-to-market accounting, such declines in values should be accounted for on its balance sheet. The immediate appearance of the loss of value on the balance sheet primarily makes short term debt financing of that hedge fund more difficult. Furthermore, assuming it has long positions, the hedge fund will be in need of more short-term rather than long-term assets to prepare for the expected illiquidity or distress in financial markets which may lead to investor redemptions by panicked investors observing the signs of distress in the hedge fund. This implies that the hedge fund should deleverage to meet its obligations towards its investors. The deleveraging of the long-term assets will further erode some of their value if all market participants are in need of deleveraging.⁶⁴ Such sales might have a significant price impact and impose costs on other investors who wish to close out their positions on those assets at market prices.⁶⁵ Therefore, sell-side hedge funds should all sell in lower prices. This implies that hedge funds should further deleverage. Since this deleveraging happens in stressed markets, it may result in fire-sales of long-term assets further eroding some of their value.

This fire-sale happens because of uncoordinated simultaneous actions of many hedge funds in need of short term financing. If such an exogenous shock affects all hedge funds or a non-negligible number of hedge funds, it will mean that they will all simultaneously pursue the same

63 Baumol and Oates, The Theory of Environmental Policy, p. 30.

64 For a thorough review of how deleveraging process works and how it affects the costs of raising capital for financial institutions, See Gorton, Slapped by the Invisible Hand: The Panic of 2007.

65 Daníelsson, Taylor and Zigrand, Highwaymen or Heroes: Should Hedge Funds be Regulated? A Survey, p. 532.

strategy, i.e., a flight to quality. This uncoordinated but individually rational action of significant numbers of hedge funds might be the best strategy for individual hedge funds, but as a prisoners’

dilemma emerges in this setting, the result of the individual rationality will be a collective disaster.⁶⁶ This sort of behavior leads to what is often called ‘fire-sale externalities’.

Such a scenario is incomplete without taking into account the interconnectedness of hedge funds with LCFIs. Hedge funds are counterparties to other LCFIs that provide them with prime brokerage services. With increased risks in hedge funds, these institutions will see the signals of trouble associated with higher counterparty risks. Accordingly, hedge funds’ counterparties will fly away from long-term assets to short-term ones to protect themselves against potential illiquidity.⁶⁷ This in turn will create greater demand for short-term financing while its supply is shrinking. Since hedge funds’ counterparties think alike and demand more short-term financing which may result in liquidity hoarding, the liquidity will decrease to a significant degree resulting in a surge in overall liquidity risks in markets. This decline in liquidity and reduced funding will certainly spill over to the real economy by increasing the cost of capital and thereby the level of input to a given economy. ⁶⁸

Moreover, this deleveraging signals to the investors that the fund is in trouble. Though due to legal, but mainly contractual restrictions such as gates and side-pocket arrangements, investors in a hedge fund cannot redeem their investment immediately, in the longer time span, the capital base of the fund will be eroded due to investor redemptions.

The need for immediate deleveraging in times of distress along with the fact that certain types of hedge funds tend to be highly levered will raise public policy concerns in times of crisis. In addition, since there is almost no limit on the trading strategies and concentrations of hedge

66 John Geanakoplos, "Solving the Present Crisis and Managing the Leverage Cycle," Economic Policy Review - Federal Reserve Bank of New York 16, no. 1 (2010), 101-131.

This is the same logic of bank runs in the absence of credible deposit insurance scheme.

67 This is one of the reasons that in times of crisis, short-term solutions often prevail over long-term ones.

68 In addition, given the effects of securitization on the velocity of money in circulation, it is suggested that the velocity of money in circulation falls when companies and individuals deleverage. Decreasing velocity of money in recession or in financial crises in which governments often try to produce or sustain certain level of inflation to avoid the money hoarding and other adverse effects of deflation means that deleveraging can potentially stall the expected impact of stimulus packages and injection of money or capital into the economy. See Susan M. Philips,

"The Place of Securitization in the Financial System: Implications for Banking and Monetary Policy," in A Primer on Securitization, eds. Leon T. Kendall and Michael M. Fishman (Cambridge, Massachusetts: The MIT press, 2000), p. 135. See also John Mauldin and Jonathan Tepper, Endgame: The End of Debt Supercycle and how it Changes Everything (Hoboken, New Jersey: John Wiley & Sons, Inc., 2011), p. 148.

funds’ positions, they are highly engaged in trading financial derivatives with embedded leverage. These factors, i.e., unlimited leverage, unlimited trading strategies, unlimited investment concentration, and heavy trading in the financial derivatives can raise concerns about hedge funds. In particular, if several hedge funds simultaneously need forced deleveraging, the impact on the liquidity in the entire market will be significant. Therefore, central to the analysis of liquidity in this section is its close relationship with the level of leverage and how deleveraging caused by illiquidity can result in systemic risk.

Nevertheless, it is equally likely that hedge funds play the role of contrarian position-takers in financial markets and provide liquidity. When the mainstream financial institutions are forced to sell their assets, mainly due to the leverage limits, hedge funds may see such instance of selling as buy opportunities, take contrarian positions to the positions of the mainstream financial institutions and thereby provide liquidity and enhance the stability of the market.⁶⁹ However, in contrast to the belief that hedge funds are liquidity providers in distressed markets or in assets which are highly illiquid, hard to value, and complex,⁷⁰ they are sometimes accused of ‘using up’

market liquidity.

It is suggested that the liquidity regulation should address the liquidity risks by focusing on minimizing asymmetric information by effective monitoring of the financial system. In doing so, it is proposed that greater transparency, along with supervision and regulation are needed for addressing such liquidity risks. It is equally important for regulation to distinguish between solvent and illiquid financial institutions and impose regulation and liquidity cushions on the institutions in need of liquidity.⁷¹

69 Daníelsson, Taylor and Zigrand, Highwaymen or Heroes: Should Hedge Funds be Regulated? A Survey, p. 532.

One of the distinguishing features of a hedge fund from a UCITS is the fact that a UCITS retains sufficient liquidity to satisfy the regular redemption rights exercised by the investors. See Angus Duncan, Edmond Curtin and Marco Crosignani, "Alternative Regulation: The Directive on Alternative Investment Fund Managers," Capital Markets Law Journal 6, no. 3 (2011), pp. 357-358.

In contrast, hedge funds often use lock-up periods and limit redemption rights of the investors. Scholars suggest that to the extent that a hedge fund locks-up the capital of its investors in illiquid investments which can provide an enhanced return in the longer investment horizons, imposing liquidity management requirements on hedge funds seems inappropriate. See Ibid.

70 Eechoud et al., Future Regulation of Hedge Funds—A Systemic Risk Perspective, pp. 275-278. See also Bianchi and Drew, Hedge Fund Regulation and Systemic Risk, pp. 13-15.

71 Kleopatra Nikolaou, "Liquidity (Risk) Concepts: Definitions and Interactions," ECB Working Paper Series 1008 (2009), p. 6.

The purpose of liquidity requirements is to ensure that there are high-quality assets that can be sold to meet sudden withdrawals of short-term funding.⁷² The regulatory tools for addressing the problems arising from liquidity is often in the form of stress-tests ensuring that the financial institutions have contingency plans for addressing potential liquidity freeze-ups. Regulators can further impose a ‘short-term funding cap,’ which essentially limits the portion of the balance sheet of the financial institution which can be funded with short-term liabilities.⁷³ The introduction of the net stable funding ratio (NSFR) and the liquidity coverage ratio (LCR) of the Basel III aims to accomplish such goals.⁷⁴ The main aim of these measures is to prevent the short-term liquidity flight which can destroy healthy financial institutions. It is argued that such a strategy can be a promising approach to address systemic risk because it acknowledges that reliance on short-term funding can be highly contagious in the event of exogenous shocks to the system.⁷⁵

Furthermore, mark-to-funding accounting rules and capital charges for liquidity risks are proposed as two additional tools to reduce the frequency and severity of the systemic liquidity events.⁷⁶ Changing accounting rules from mark-to-market to mark-to-funding is proposed as a proper mechanism to measure the liquidity risks of financial institutions. Such a shift in accounting rules takes account of funding risks in measuring the total value of the firm. Mark-to-funding approach suggests that the pools of assets secured by long-term assets do not have to be marked-to-market. If such pools of assets are not marked-to-market, the likelihood of the market illiquidity stemming from the forced sales will be mitigated. In addition, financial institutions engaging in the maturity and liquidity transformation (institutions holding assets with low market liquidity and long-term maturity while funding them with assets with short-term maturity) should incur higher capital charges. Such a mechanism is proposed to internalize the systemic

72 Hal Scott, "Interconnectedness and Contagion," Available at SSRN (2012), pp. 9-10.

73 Ibid.

74 For a detailed discussion of these two measures, see Roberto Ruozi and Pierpaolo Ferrari, Liquidity Risk Management in Banks: Economic and Regulatory Issues (New York: Springer, 2013), pp. 29-40.

75 Hal Scott, "Interconnectedness and Contagion," Available at SSRN (2012), pp. 9-10.

The alternative to liquidity requirements is the emergency public lending facilities. However, it is argued that such requirements which can protect against the liquidity-driven runs are of limited effectiveness and the role of central banks in providing liquidity will remain essential in guarding against contagion. See Scott, Interconnectedness and Contagion, pp. 9-10.

76 Brunnermeier et al., The Fundamental Principles of Financial Regulation: Geneva Report on the World Economy, pp. 39-40.

externalities of liquidity.⁷⁷ Although capital requirements can potentially address liquidity problems, since contagion often spreads in runs which are driven by liquidity problems, liquidity requirements are often perceived as more promising compared with capital requirements.⁷⁸