A Robust and Interpretable Liquidity Proxy

In this paper we provide an operational definition of market and funding liquidity, and we introduce a method to create two interpretable liquidity measures, which we associate to these two types of liquidity. The construction is based on creating two parsimonious linear combinations of the many liquidity proxies often used in the liquidity literature. We show that all these underlying proxies display mean-reverting behaviour, but are characterized by very different reversion speeds. The differences in reversion speeds are inherited by our two liquidity measures, which naturally sort the underlying proxies into slowly and fast mean-reverting. Given our model, we manage to attribute a precise financial interpretation to our two liquidity measures. Our construction does not require transaction-level data (such as volume or bid-offer spreads), and correlates well both with other measure that do, and with liquidity proxies (liquidity as 'noise', liquidity as broker-dealer leverage) recently introduced in the literature. We show a possible application of our measure to an asset pricing problem.