Deutsche Banks wants a liquidity formula

(Wikimedia Commons)Right now, people in markets are worried about one big thing: liquidity.

But there's a problem: no one is exactly sure how to define or measure it.

This week, Peter Hooper and his team at Deutsche Bank wrote a big report dissecting the subject of liquidity and defined it — or tried to — as follows:

What do we mean by market liquidity? Although there are potentially many different definitions of market liquidity, in its simplest form we think of a liquid market as one in which trades can be executed with some immediacy at low transaction costs. But even within this short and simple definition there are many uncertainties: Does this refer to all trades, regardless of size, or only trades of a "normal" size? What constitutes a low transaction cost, and how do we best measure this? Because of these uncertainties, there is no single best metric for the level of liquidity in a market.

Let i be the probability of a trade relative to the total market. Then we want -iLog(i) less than 1.0 . Now this makes a bold assumption, namely that the stock market or bond market trades paper coherently with the economy it measures, and the economy is adiabatic.