Sunday, July 29, 2007

Updating definitions of terms related to money, capital, and liquidity

Many terms used in finance and economics have been in use for an extended period of time, but there is also a lot of evolution of our economic and financial systems going on and meanings of terms evolve as well. My motivation for this post is to clarify the common use of the term liquidity, as when people say "the world is awash with liquidity."

My goal here is not to redefine existing banking terms, but rather to focus on how the terms are using in the world outside of banks. My terms basically end where the world inside of the banking system starts.

My definitions here are still in rough draft form. I'm actually not happy with them yet, but I'd rather get them out there for discussion rather than spend a lot more time tweaking them in private. I have consulted a number of sources for existing definitions, but I'm confident that a bit more research will help me identify even tighter and broader definitions.

To summarize this whole post: I would define "liquidity" as the ready availability of capital, regardless of whether that capital is money in the bank, a venture investment, a loan, a credit line, or any other credible "source" for "money."

Traditionally, the term liquidity has been used to refer to a market in which assets (typically securities) can be promptly exchanged for cash at a price which is reasonably stable (or rising.) A liquid market is a market in which owners of assets can feel confident that they can at any time sell those assets promptly and without having to take a substantial "haircut" on the price that they perceived to value those assets well in advance of their decision to sell. A liquid asset is an asset for which there is a liquid market. In other words, a liquid asset can be readily converted into cash. An individual or entity is said to be liquid if they are capable of covering their liabilities with their assets, implying that there is a liquid market for the assets they would need to sell to cover their liabilities.

An illiquid market is a market in which the sale of assets cannot be arranged promptly or if the sale would be at a much lower than expected price. An illiquid asset is an asset for which a liquid market is not readily available. An individual or entity is said to be illiquid if they are not capable of covering their liabilities with their assets, implying that there is not a liquid market for the assets they would need to sell to cover their liabilities, or at least their liabilities which are due promptly (in the very near term.)

In essence, the traditional use of the term liquidity is to refer to non-cash assets and the ease of readily converting them to cash at a decent price.

I do not believe that I am describing or defining anything new there.

But today, people throw around the term liquidity as in "global liquidity" or "the world is awash with liquidity", not in reference to non-cash assets, but in reference to "cash" itself which is readily available to acquire assets.

I suggest that we are stuck with a term that has three alternative definitions:

Liquidity is either: 1) the ease with which a market can be used to readily convert an asset to cash at a price near the price quoted by the market for an extended period of time before the actual sale of the asset, 2) the degree to which an entity could readily convert assets to cash to cover liabilities, and 3) the degree of availability of buyers and investors and lenders with "cash" ready to purchase assets or make investments or make loans.

That's a good rough definition, but some issues remain.

First, what is "cash"? The term is used rather loosely. Well, it certainly isn't simply paper currency in your wallet and the coins in your piggy bank. My third definition for liquidity also needs to cover cases where investors have ready access to credit lines.

I suggest substituting capital for cash in my third definition.

But even to make sense of that definition, we need to get a good handle on the basic terms.

Since most financial transactions are performed electronically, cash has to exist in electronic form as well as its ultimate physical form.

If we are going to talk about cash, then we also need to relate it to or distinguish it from money.

We also have to relate and distinguish cash and cash equivalents.

I would propose the following multi-definition for cash:

Cash is either 1) currency, 2) a loose synonym for money, or 3) extremely liquid assets.

In some contents, cash really does mean money in your pocket, such as paying for a good or service "in cash."

In many contexts, cash and money are used as interchangeable loose synonyms.

Extremely liquid assets are assets for which an extremely liquid market exists.

An extremely liquid market is a market which has extreme liquidity.

Extreme liquidity means that an asset can be so promptly and reliably converted to "cash that most market participants consider such an asset as good as cash. An example of the latter would be short-term U.S. Treasury debt and money market mutual funds.

It is a matter of debate whether commodities such as oil, copper, or even gold, should or shouldn't be considered extremely liquid assets. I would argue that at least in the context of "cash", an asset is extremely liquid only if its nominal value will not decline over a period of time. Sure, inflation and foreign exchange rates can cause the "value" of even currency to decline, but commodities can decline in value even as a deposit in a money market account rises. In the end, my definitions here don't depend on whether commodities are included as extremely liquid assets. I would characterize them as very liquid assets.

The whole point of extremely liquid assets is that "money" can be "stored" in a wide variety of forms just as long as those forms can be converted and consolidated into a "balance" in a financial institution that can be electronically "wired" to another financial institution.

Money is: either: 1) currency, 2) a deposit at a financial institution, 3) special arrangements between financial institutions and central banks which effectively act as if they were real deposits, or 3) a loose synonym for cash.

(I'm not happy with this definition. It needs to be both tightened and broadened.)

A liability is either: 1) a contractual obligation such as a loan or lease, 2) a governmental obligation such as taxes, 3) a court-ordered obligation such as a judgment, or 4) some other form of "commitment" to disburse funds in the future.

An asset is either: 1) property (physical or intellectual) or 2) a financial asset.

A financial asset is either 1) money or 2) a security which can be bought and sold on a financial market

Capital is either: 1) money or 2) credit.

Credit is either: 1) money that is made available to a borrower by a lender in consideration of either their ability to repay the credit or the value of collateral provided by the borrower and held by the lender, 2) a credit line, or 3) a credit card.

A credit line is the prearranged future availability of an agreed upon quantity of credit in advance of the actual access to that credit. The key is that the creditor does not need additional approval from the lender to access the money represented by the credit line.

A credit card is physical object, usually a thin card usually plastic and usually rectangular, use to identify a credit line in a financial or commercial transaction.

Currency is either: 1) the unit of value for financial  and commerce transactions as defined by a governmental entity within an economic community, 2) a quantity of currency, 3) physical currency, 4) electronic currency, .

Physical currency is either paper currency or coin.

Paper currency is either: 1) a type of physical piece of paper printed by a government agency to represent a quantity of currency, 2) a single piece of paper currency which represents a specified quantity of currency value, or 3) a quantity of individual pieces of paper currency.

A coin is either: 1) a type of physical object (other than paper currency) and usually metallic and usually a disk which is manufactured by a government agency to represent a quantity of currency, 2) a single coin which represents a specified quantity of currency value, or 3) a quantity of individual coins.

That about covers it. I think these terms give a detailed enough view for people to understand the interactions between liquidity, money, capital, cash, and credit.

I will continue to research and refine these terms. At least this is a starting point.

I cannot dictate how others should use any of these terms, but at least my readers will have a clue as to what I mean when I use these terms.

-- Jack Krupansky

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