Illiquidity is a function of total transaction costs, which can be considered barriers to entry. (and exit…)
Not everything can be liquid; not everything should be liquid; not everything will be liquid.
I ran into the concept of complete markets for the first time while taking a graduate level economics of risk class at UC-Davis. Lots of time spent on the Arrow-Debreu model. Quoting:
The Arrow–Debreu model applies to economies with maximally complete markets, in which there exists a market for every time period and forward prices for every commodity at all time periods and in all places.
But as with many other economic models, the assumptions are unrealistic aside from some special cases like widely traded options and commodities markets. For markets that are by necessity thin (which in the Arrow-Debreu sense as I read it is most markets) examples being buying or selling a certain house, an obscure bond, or offering/receiving credit default on a thin slice of a securitization, there is no way that complete markets could exist.
It takes effort to make a market in any commodity/security. You have to know something about the commodity/security, and know about the buyers and sellers. What motivates them? What is their “bite size? (what their normal position size is)” When should I be concerned that some market player knows something that I don’t? How much can I bid and offer under normal conditions, and at how tight of a bid-ask spread? How much must I offer under stressed conditions, and how wide of a bid-ask spread will the market players tolerate?
It costs money to make a market, and so, market-makers conserve on making markets, and only offer deep markets on widely traded instruments. The same is true for markets that offer delivery at different times and places. Things that many people want, over long periods of time, that are highly standardized, can develop into broad futures and options markets.
But what lends to illiquidity?
- Specialness implies lack of information. An obscure fixed income security might have a very high yield compared to its rating and likely maturity. The costs of research, and the efforts that must be expended in bargaining drive many players away from unusual securities.
- An asset subclass can be new, and there are few transacting in it. That is another version of the former problem.
- A security might be fungible but illiquid because of a large number of legal steps one has to go through in order to move the security. Examples would include selling loans on the balance sheet, or selling real estate supported by tax credit, or credit tenant leases.
- Lack of information can also relate to the size of the asset in question. Big players with large research staffs focus on large and maybe mid-cap assets. But few of size focus on micro-caps, they could not put enough money to work.
Now, when I was a bond manager, because my client had a large amount of long noncallable liabilities, I bought less liquid debts when I received adequate compensation to do so, but not more than my client’s balance sheet could tolerate. That allowed me to make better money for my client, but without increasing risk. Hey, use the advantages that you have.
But remember, even if you understand the illiquid security perfectly well, but you don’t understand your own liquidity situation, you might find yourself in a situation where you have to sell, but few others understand the security, and no good bids are offered.
I would add that even in liquid markets, there are large order sizes that render markets illiquid, at least for a time. Having owned 10, 20, 30% (even 80% ugh) of a given bond issue, I knew that I could only accumulate and decumulate in dribs and drabs, and contented myself with being a pseudo market maker, who could buy if the price was attractive, hold under all conditions, and sell if a loony buyer or buyers showed up.
Phrasing it differently: we only hold illiquid assets, or illiquid amounts of assets when we know a lot more than the market. We have paid the barrier to entry, and are the heavy hitter now. We make money off of superior knowledge, though illiquidity means that trades will be infrequent.