The consequence of a mark-to-market accounting regime and regulation based upon that for investors is that the stabilising influence of these investors is diminished and market stability impaired as the speculators come to dominate. In this circumstance, markets cannot perform their critical economic resource allocation role. The market itself becomes a source of pro-cyclicality that has so troubled the regulatory authorities.
There is another related disjunction – in the academic liquidity literature. In the macroeconomic analysis liquidity is costly and harmful, but in the market microstructure it is desirable. Now it is obvious that liquidity must have a cost; if it did not all assets would be liquid. This runs contrary to much analysis where, incorrectly, it is illiquidity which has a cost. In markets we are concerned with instruments which are negotiable, which contain an option on liquidity. A bond which is non-negotiable yields more than a bond which is tradable. This has long been exploited by sovereign debt management offices, which go to great lengths to maximise the negotiability of their securities, lowering their issuance costs.
If we consider the risk-free rate of financial theory to be a pure liquidity preference rate, then it is immediate that this rate lies above the rate on the zero-coupon government of the term of interest, since that security is negotiable, as it contains an embedded option on liquidity. Contrary to popular belief low rates do not provide information about future returns, what these low rates are telling us is that future liquidity is expected be high (in relative terms). The implicit terms of the liquidity option of a negotiable security are fixed at the time of purchase of that instrument; the costs are realised when it is exercised on sale. A buy and hold strategy never exercises this option, but the option still has a cost to the strategy. The security had a higher price at acquisition, which lowered the income yield and this liquidity option is a pure sunk cost. When current market liquidity is low, the implicit cost of the option is low. When current market liquidity is high, the implicit cost of the liquidity option is high. We really do make the worst of deals in the best of times.
The liquidity available in a market is principally exogenous to that market; it is determined by the level of savings and the real investment demands in the economy. The liquidity provided by financial intermediaries, such as dealers, is limited to their capital employed. There is an efficiency dimension in the velocity of this inside liquidity but that is merely an intermediate step in the transfer of liquidity from saver to investor user. It appears that under financial liberalisation, the inside sector has grown far beyond anything necessary merely to smooth the flows from savers to users of capital and that the rents extracted for these intermediation services are material drags on the economic performance of savings. As the philosophy of market-based financial liberalisation loses influence, we may expect the financial sector to shrink, and with that lower inside activity to occur, which suggests lower use of derivatives. As the developments in the US, Holland and Scandinavia have shown, the use of fair value accounting and regulation based on that is beginning to be rolled back. Solvency II is the swan-song of the old and discredited school.
The future for fund management
As for fund management, the future is not about asset allocation and ever more clever and complex strategies for the management of assets and liabilities, nor is it about ever more sophisticated risk management, but rather of the management of cashflows. In this world, performance and skill will be concerned with the improvement to the income yield. Here, transparency of costs and fees are the friend of the investment manager.
This is a world in which fund managers will be far less concerned with second and third guessing the behaviour of markets and others than previously and far more concerned with the actions of the authorities. It will become necessary to consider the recently unthinkable; taxes, controls and many other interventions are now possible, and many even likely.
If, as many argue, these are extensively evaded or even just avoided, we should not be surprised by an official response of ever more draconian changes in regulation. Even such shibboleths as the tax-deductibility of corporate interest payments on debt capital are being revisited.
The relevant quotation now is not James Carville’s wish to be reincarnated as the bond market but rather another of his aphorisms: “[Republicans] want smaller government for the same reason crooks want fewer cops: it’s easier to get away with murder.”
Comments