Until recently the financial services lobby was apparently having considerable success in delaying, obstructing and watering down many of these proposals. However, with the public travails of JP Morgan, HSBC, Barclays and many more, it seems that this lobby is now more than ever likely to be ineffectual. The financial world is changing and the recently unthinkable now requires consideration.
This is nowhere more relevant than in the asset management industry. The vocal, and often exaggerated, claims of excessive costs and fees are just one symptom of this need. Risk acquired a surprising centrality in financial regulation, even though ex ante, it is unobservable and ex post, it is disputable. Indeed the very feasibility of its estimation or measurement is questionable. The risks of financial markets differ in material ways from those of natural hazards. Insuring against flood or earthquake is a game against nature; we really cannot affect the likelihood of the event. Mitigation may be important in terms of the total loss incurred, but carrying an umbrella does not change the likelihood of rain, though it may save our clothes from ruin.
Financial markets, by contrast, are predominantly games against others. In describing markets as places where “men meet to deceive”, Democritus was not entirely wrong. In other words, most of the risks of financial markets are of our own collective creation, rather than naturally occurring hazard, and, perversely, all too many of the ‘solutions’, the hedges to these financial risks are yet more financial contracts.
To be perfectly clear, the only perfect hedge of a financial asset is its sale. This makes immediately obvious the central fl aw of this now-dominant management style; it reduces the investment fund to cash. This is entirely inconsistent with any idea of investment and deferred consumption.
The role of liquidity
Until the crisis, liquidity did not figure in any meaningful way in banking regulation. The argument of the liberalisation school was that liquidity was always available from the central bank in its role as lender of last resort; experience has entirely discredited that canon, along with much else. If we use the ultimate source of liquidity to define and distinguish between investment and speculation, we can advance the discussion and resolve a few conundrums.
We shall define speculation as reliance upon a market for its future liquidity. This is sale in a market, reliance upon the market price at some future date. By contrast, we will define investment as reliance upon a specific obligor under the terms of a contract. In this view, the saving deposit placed in a bank by an individual is investment. The treasury bill bought and held to maturity is investment. The equity bought and held solely for the collection of dividends is investment. Time, or the holding period, is material here. The return performance of an equity held for a few microseconds is determined entirely by price. That same equity’s returns when held for a hundred years or more will be predominantly determined by the income received from it. This has long been known to the asset management industry – it usually takes the form of statements to the effect that asset allocation is the most important management operation for performance (Beebower, Brinson et al is the usual citation).
However, the dissonance of this with the long-term is rarely commented upon, though its academic credentials are also impeccable (Dimson, Marsh and Staunton – Triumph of the Optimists). This point warrants emphasis – the long term is about income and income growth while the short term is about price movement.
Hedging is immediately obviously a form of speculation concerned with movement in price – as is most of the risk management that we observe in markets. This is fuelled and exaggerated by ‘fair value’ or mark-to-market accounting, which can be seen as another strand of the liberalisation philosophy. If I have purchased a gilt strip as an investment so that I hold this to maturity, any intermediate price is immaterial to the liquidity I will receive at maturity. If I purchase a coupon paying government my income yield is not determined by the intermediate prices, but rather by the initial price at which I purchased the security. In fact, the total return achieved increases as prices decline and intermediate reinvestment yields increase. Declining prices are the friend of the investor, they offer better opportunities and higher returns, but they are inimical to the speculator (unless short).
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