I recently participated in a Centre for the Study of Financial Innovation roundtable discussing the PWC’s recent global financial markets liquidity study, which was commissioned by the Global Financial Markets Association and the Institute for International Finance. The first of many problems is that the study does not observe that market liquidity is illusory and reliant upon a convention.
As Keynes noted: “It forgets that there is no such thing as liquidity of investment for the community as a whole” and “for if there exist organised investment markets and if we can rely on the maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news …”
The recent behaviour of the Chinese markets provides yet another classic illustration of the liquidity illusion. Prior to its recent corrections, or at the height of the bubble, turnover in Shanghai was materially higher than in New York, the highest in the world. The exchange even had to modify its software to accommodate numbers so large. The PWC study states: “… we … work on the premise that market liquidity is invariably beneficial”, when the Bank of England has published the Final Report of the Fair and Effective Markets Review last June, which states: “Pre-crisis liquidity in some markets was in general too plentiful, causing sharp reversals or even closures during the adjustment phase, which harmed rather than enhanced effectiveness.”
Part of the problem is simply that the PWC study fails to recognise that liquidity has a cost. If it did not, all assets would be liquid. Indeed, it would be rather difficult to explain the seigniorage collected by central banks from the issuance and distribution of money, or to devise explanations of the transmission channels through which central bank open market operations work if this were not the case.
The fact that liquidity has a cost means that we should be parsimonious with it. This is not motivated by some Victorian notion of thrift as a virtue, but because of the cost to the economy in sub-optimal output if we are spendthrift with it. Here there is also a precautionary motivation, since under uncertainty the private sector may not produce sufficient liquidity. Of course, this is a reflection of public good nature of liquidity. Optimal management of institutional liquidity may result in sub-optimal liquidity at the level of the economy and fail to be supportive to the social ends; these externalities can justify regulation of liquidity. There is something of a dichotomy in the academic literature on the question of liquidity. Most of the microstructure literature considers liquidity to be beneficial, while much of macroeconomics does not.
Even though this difference can currently be simply resolved by observing the capital markets are presently performing their economic functions rather well; corporate and government bond issuance is at unprecedentedly high levels, even though secondary market turnover is languishing.
The failure of equity markets to perform their economic function as a source of capital for industry and commerce, even in the presence of high liquidity, has been a pillar of the corporate governance literature.
The PWC study emphasises repeatedly that recent regulatory changes to financial services companies hold the prospect of lowering market liquidity – indeed, not only is that true, but also much of this appears to have already happened. However, this is incidental to the primary regulatory purpose of making our financial institutions and system more resilient.
One of the more surprising aspects of the Fair and Effective Markets Report is its apparent love affair with the idea of standardisation of corporate bond issuance terms. The Market Practitioner Panel is broadly supportive of this idea even though it notes “For the standardisation of corporate bonds to be desirable for issuers, there need to be tangible benefits arising from standardisation, such as lower yields versus bespoke bonds”. Another way of phrasing this would be that the corporate treasurer will require compensation for the basis risk that is incurred by issuing these securities rather than exactly what is appropriate – and of course, there is no discussion of the lower returns resulting for investors.
By way of a little devilment, how should covenants be standardised? The fundamental problem is that, beyond a basic level, increased liquidity benefits insiders much more than it benefits the users of these markets, the issuers and the savers.
Among other things, this means that insiders (and their lobbyists) will be disproportionately represented in the responses to consultations and the membership of practitioner bodies. It would do no harm to remember why and for whose benefit these markets exist. The convenience and profits of insiders are rarely congruent with the welfare of outsiders. The real question is how much market liquidity is truly needed, since its cost will ultimately, and inevitably, be paid by the economic users, not market practitioners.
Con Keating is head of research at BrightonRock Group
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