Anthony Hilton: Why liquidity is drying up as a market driver

Ask anyone in the City what makes a market and they will say liquidity, the ability to find a buyer for anything you want to sell, or conversely a seller for everything you might want to buy.

It is liquidity which separates the serious markets from the also-rans and distinguishes London from most of the competition. It is liquidity which ensures the keenest prices and therefore the lowest possible cost of capital business.

It follows that anything which damages liquidity is to be resisted.

Thus moving the euro clearing market to the Continent after Brexit would be a disaster because it would fragment the market and hit liquidity. A transaction tax must also be resisted because it would add to the costs of trading and thus reduce liquidity.

City people tend to say all this without thinking much about it, but it is no longer really a reflection of how they behave.

Liquidity might have been the watchword of investment managers 10 years ago, but now they are driven by the need to find yield and whether that return comes from something liquid or illiquid is no longer such a big issue.

It has dawned on them too that many of the investments praised for their liquidity are not actually very liquid at all, particularly in bad times when you might need to sell.

Star fund manager Neil Woodford has 15% of Provident Financial which late last month published seriously bad results and the shares dropped 66%. It is a large listed company.

Does anyone think Woodford could have sold at a sensible price that day?

Another mantra is that Government bond markets are always liquid.

But central bankers round the world are dreading the circumstances in which this might be put to the test because the history of recent crises is that when markets are seriously dislocated, liquidity vanishes and investors are trapped.

But the most interesting reason things are having to change is the aforementioned search for yield.

Because conventional listed investments no longer deliver the returns investors want, but insurance companies and pension funds still need to meet their promises, the investment industry is fundamentally rethinking its attitude to unlisted investments.

This is because the returns on unlisted investments have traditionally been higher, precisely to compensate for the uncertainty around whether they can easily be sold in a hurry. This is what is known as the illiquidity premium.

Legal & General is making a virtue of this shift, putting investor funds into green energy, infrastructure and housing and even building a factory to make prefabricated housing units.