From what I’ve been able to gather, Liquidity just means being able to get out of a bad decision at little to no cost.
Basically no one wants to hold risk anymore, but still have growth… which is the fundamental flaw in the markets that continues to rear its ugly head in exotic derivatives
Liquidity only eliminates the type of risk that is associated with liquidity. Having less liquidity risk does not in any way mean you're more likely to lose money in general.
Less liquidity means there's a larger bid-ask spread: if you're in a rush to either buy or sell, there's a chance you'll pay a premium for a quick trade. If you're not in a rush, you probably won't pay this premium at all.
Saying that liquidity reduces is a fallacy that was believed quite heavily pre-2007.
Liquidity does not reduce risk, it has no effect on risk because it has no effect on outcomes. If you invest in a stock that goes bankrupt, there is no way to get out of that decision with no cost.
Equally, someone is only willing to supply that liquidity if they get something in return. So in those worst cases, you will usually not have the liquidity that you think because someone needs a return for taking the elevated risk in those situations (and again, that risk doesn't go anywhere, liquidity just shifts that risk to someone else).
Look at the market, is there really a deficit of risk-taking? I think there is a deficit of understanding of the risks but there is a massive excess of risk-taking in pretty much every asset class.
I also wouldn't associate illiquidity with return either, that is quite wrong. The decentralized market-making model that we have minimises costs and maximises liquidity but this is just a net gain for investors (due to the clear demarcation of types of risk-taking within the system). There is no real illiquidity premium, and the societal gain from higher liquidity is just a pure gain for the system (again, I am not saying it reduces risk, it does not but it does reduce costs, increase transparency, and produces a system that is robust relative to bank-led financing systems common in Europe, for example).
> Look at the market, is there really a deficit of risk-taking? I think there is a deficit of understanding of the risks but there is a massive excess of risk-taking in pretty much every asset class.
There's a deficit of risk-taking in a crisis (and maybe an excess of risk-taking in "normal" times). In the old days crises would be softened by market makers who were willing to act as de facto prop traders and buy at the bottom for their own account - an extremely risky trade ("falling knife") but an extremely lucrative one if you get it right. Nowadays the algorithmic herd just exits the market when times go bad, and if you did do the trade and make a killing then you'd get your trades broken ("clearly erroneous") and have to fight a lawsuit and it just wouldn't be worth it.
Shifting risk is not productive — it may be in some “economic” model, but by the hand of the market it is waste heat - and only compounds the probability of edge cases.
People shave off a return for holding the hot potato! Not one factory is built, not one wage increases, and not one investment made save for the HFT yacht.
This gets at my problem with the secondary market in general and why I believe dividends should be the only repayment terms for equity… it would align with the tax favors bestowed in our current market
Basically no one wants to hold risk anymore, but still have growth… which is the fundamental flaw in the markets that continues to rear its ugly head in exotic derivatives