Urgent review needed.
Having been unplugged for a few weeks, it is time to respond to some questions and comments. First up: Is this a true picture of Unemployment or an Internet slam/scam on the recent failures of Obama and others? I would be interested in hearing your thoughts.
UNEMPLOYMENT MAP: THE GEOGRAPHY OF A RECESSION
Take a look at this map. It shows how the unemployment rate has changed over the past several months. When you get to the map, click the arrow in the middle and watch how things changed. Incredible what "The Great Recession" has done. The old saying, "A picture is worth a thousand words" is never more true than looking at this map. Viewing it only takes a few seconds. The darker the color, the higher the unemployment. 2009 has been BRUTAL. Unemployment Rates by County--January, 2007, approximately one year before the start of the recession -- to the most recent unemployment data available today (May, 2010).
http://cohort11.americanobserver.net/latoyaegwuekwe/multimediafinal.html
It is an accurate picture of one of the unemployment rates, and worth viewing. However, there are numerous ways to measure unemployment. The particular one used for the mapping is not particularly meaningful. That said, the one selected doesn't matter too much for a broad brush overview of the geographic spread of the recession.
The unemployment rate used does introduce some "bias" in the time dimension. There is a slight bias toward greater absolute change and a lag in timing when this particular unemployment rate is used.
To understand the issues consider those who “want to work but have given up looking.” Giving up on job seeking should take time, thus the built-in lag. Add in the subjective nature of discouragement and things get interesting. Does the unemployment rate as measured by job seeker influence it? If so, it becomes self-referential in that the rate of unemployment becomes a function of itself. Self-referential variables can become unstable. They can just exaggerate their own cycles. Now consider what it measures. Are you discouraged today? Does it measure something other than consumer confidence? Who wouldn’t work if the prefect job were offered? Most retirees, kids, home makers, etc. would enter the labor force if offered a job doing nothing and getting well paid for it.
People who are employed part time but would like to work full time are included. I’ve always wondered about people working full time but who would like to work part time. Job sharing is a recent phenomenon. Including part time workers raises a question about what is being measured. The Hedged Economist worked part time throughout college and grad school. If offered a full time job at post grad rates, would I have taken the job? If so, where would that put me? I wasn’t unemployed; I was a student. I had a job and thus was employed (part time).
My suggestion is ignore the unemployment rate and focus on the change in employment if you want to measure how an economy is doing. Notice the term was employment; not jobs. It is the failure to realize that employment and jobs aren't synonymous that is the Achilles heal of this recovery.
Saturday, July 31, 2010
Saturday, July 10, 2010
The discussion Congress should be having: PART 3, Punishing the innocent.
What happened to my nest egg, my pension, my IRA?
As is noted in Urgent Speed: Why Ten Million Dollar IPOs Matter: to quote: “…with the proliferation of derivatives the seed stage asset class is one of the few uncorrelated asset classes.”
This is an issue discussed in some detail is The Hedged Economist: Angels, entrepreneurs, and diversification: PART 2 , as well as Part 3 and 4. and the Epilogue to Angels, entrepreneurs, and diversification. Unfortunately, people haven’t connected the dots. If one can’t diversify, the options are to accept volatility in investment prices. And, yes, that includes pensions, IRAs, and nest eggs with no intention of directly participating in early stage investments. One could trace the linkage through markets, fund investments, capital flows into later stage investments, etc., but the generalization is simply that reduced diversification makes the entire economy more volatile without increasing growth.
Ultimately it inhibits job growth. The reason it inhibits growth should be a question that answers itself. Seems every commentator has discovered small business creates the majority of new jobs. But, they fail to point out the inconsistency between small business job creation, and the culture of dependency and the psychology of victimization in the US. Besides, there are very few opportunities for our “leadership” to claim success for a healthy small business sector.
Spreading the wealth is a poor substitute for creating the wealth, but it is a lot easier; sort of the lazy man’s solution. Problem is it doesn’t create jobs. It creates more dependencies.
Nice thing about jobs is that a good number next month will cause many people to ignore how dismal a failure the last year has been. But, unless the last six months get revised away, anemic is still the operative word.
Our “leadership” doesn’t like to point out that the US has a major bias against investment. They seem to fear that someone could loose money, or even worse, someone might make some money. But, they found a solution. Tilt the economy toward consumption.
If lack of consumption is the problem, one has to explain cars that are larger than families; excess housing inventory; families with more TVs, phones, etc. than family members; toys that are replaced almost weekly; consumption that routinely exceeds output (thus a trade deficit); why one can borrow to buy a house at record low interest rates but can’t get a loan to start or expand a small business; zero percent down and no payment for X; and so on.
We currently have a debate going on about fiscal policy. It is all noise unless someone introduces the question of how to address the issue of subsidies for consumption and hostility to small business -- especially toward startups.
As is noted in Urgent Speed: Why Ten Million Dollar IPOs Matter: to quote: “…with the proliferation of derivatives the seed stage asset class is one of the few uncorrelated asset classes.”
This is an issue discussed in some detail is The Hedged Economist: Angels, entrepreneurs, and diversification: PART 2 , as well as Part 3 and 4. and the Epilogue to Angels, entrepreneurs, and diversification. Unfortunately, people haven’t connected the dots. If one can’t diversify, the options are to accept volatility in investment prices. And, yes, that includes pensions, IRAs, and nest eggs with no intention of directly participating in early stage investments. One could trace the linkage through markets, fund investments, capital flows into later stage investments, etc., but the generalization is simply that reduced diversification makes the entire economy more volatile without increasing growth.
Ultimately it inhibits job growth. The reason it inhibits growth should be a question that answers itself. Seems every commentator has discovered small business creates the majority of new jobs. But, they fail to point out the inconsistency between small business job creation, and the culture of dependency and the psychology of victimization in the US. Besides, there are very few opportunities for our “leadership” to claim success for a healthy small business sector.
Spreading the wealth is a poor substitute for creating the wealth, but it is a lot easier; sort of the lazy man’s solution. Problem is it doesn’t create jobs. It creates more dependencies.
Nice thing about jobs is that a good number next month will cause many people to ignore how dismal a failure the last year has been. But, unless the last six months get revised away, anemic is still the operative word.
Our “leadership” doesn’t like to point out that the US has a major bias against investment. They seem to fear that someone could loose money, or even worse, someone might make some money. But, they found a solution. Tilt the economy toward consumption.
If lack of consumption is the problem, one has to explain cars that are larger than families; excess housing inventory; families with more TVs, phones, etc. than family members; toys that are replaced almost weekly; consumption that routinely exceeds output (thus a trade deficit); why one can borrow to buy a house at record low interest rates but can’t get a loan to start or expand a small business; zero percent down and no payment for X; and so on.
We currently have a debate going on about fiscal policy. It is all noise unless someone introduces the question of how to address the issue of subsidies for consumption and hostility to small business -- especially toward startups.
Wednesday, July 7, 2010
The discussion Congress should be having: PART 2, Whose ox did we gore?
Where are the start ups?
US NEWS AND WORLD REPORT made an interesting comment in a piece on financial regulatory financial reform (“4 Things Financial Reform Won’t Do For You - Rick Newman (usnews.com)” ). The relevant section is quoted below. It lists one of the things the legislation won’t do as:
“Come up with creative financing. While clamping down on risky lending, banks and their government overseers have also denied credit to many who legitimately need it. Scarce credit is especially hard on small-business owners, who often use bank loans or credit cards to pay suppliers or stay current on rent. The stranglehold on small business is one reason hiring is weak and the whole economy is fragile, because small business accounts for an outsized portion of new jobs. The government thought it would solve this problem by bailing out the banks, which in turn would inject more money into the economy, but it hasn't worked out that way so far. So, many people who desperately need credit have had to tap friends or family, mortgage assets, hastily improve their creditworthiness and find unconventional sources of money.”
This may sound a bit familiar to anyone who read “The Hedged Economist: Angels, entrepreneurs, and diversification: PART 1.” It pointed out the importance of family, friends, mortgages, and credit. But, it also argued that other sources of capital are essential. My contention is that by making the environment hostile to start ups and self employment, the entire economic food chain is given stomach cramps. Nothing makes the environment more hostile than choking off credit.
But, it is worth noting that the problem isn’t just financial reform. This blog pointed out back in March in “The Hedged Economist: Regulatory capital and who’s got the money?” that for bank stability and ultimately economic stability “Increased capital is ultimately the solution. But, timing changes is probably more important than the level. What we know about reserves is that people lower them in good times and raise them in bad times. We also know this aggravates the cycle. Well, surprise, surprise, governments are people; they do the same thing. Unfortunately, the government has a long history of changing capital requirements in the wrong direction over the business cycle. It’s the fallacy of composition writ large. Individual banks are safer with higher reserves, but if every bank raises more capital, oops, no credit even for productive endeavors.” So, regulatory reform is just aggravating a bad situation.
So, while the IPO market has problems of its own, one should never underestimate the importance of the general economy. “General economy” is a nice way to say “how people get by.” Make getting by dependent on government and sooner or later government runs out of rabbits in its hat. Further, governments, and for that matter, the media have problems with amorphous, self-contradictory, disorganized (maybe self-organizing) bunches of people. If amorphous, self-contradictory, disorganized or self-organizing doesn’t sound like how people get by, go out and talk to you neighbors, friends, relatives, and be sure to include some strangers.
US NEWS AND WORLD REPORT made an interesting comment in a piece on financial regulatory financial reform (“4 Things Financial Reform Won’t Do For You - Rick Newman (usnews.com)” ). The relevant section is quoted below. It lists one of the things the legislation won’t do as:
“Come up with creative financing. While clamping down on risky lending, banks and their government overseers have also denied credit to many who legitimately need it. Scarce credit is especially hard on small-business owners, who often use bank loans or credit cards to pay suppliers or stay current on rent. The stranglehold on small business is one reason hiring is weak and the whole economy is fragile, because small business accounts for an outsized portion of new jobs. The government thought it would solve this problem by bailing out the banks, which in turn would inject more money into the economy, but it hasn't worked out that way so far. So, many people who desperately need credit have had to tap friends or family, mortgage assets, hastily improve their creditworthiness and find unconventional sources of money.”
This may sound a bit familiar to anyone who read “The Hedged Economist: Angels, entrepreneurs, and diversification: PART 1.” It pointed out the importance of family, friends, mortgages, and credit. But, it also argued that other sources of capital are essential. My contention is that by making the environment hostile to start ups and self employment, the entire economic food chain is given stomach cramps. Nothing makes the environment more hostile than choking off credit.
But, it is worth noting that the problem isn’t just financial reform. This blog pointed out back in March in “The Hedged Economist: Regulatory capital and who’s got the money?” that for bank stability and ultimately economic stability “Increased capital is ultimately the solution. But, timing changes is probably more important than the level. What we know about reserves is that people lower them in good times and raise them in bad times. We also know this aggravates the cycle. Well, surprise, surprise, governments are people; they do the same thing. Unfortunately, the government has a long history of changing capital requirements in the wrong direction over the business cycle. It’s the fallacy of composition writ large. Individual banks are safer with higher reserves, but if every bank raises more capital, oops, no credit even for productive endeavors.” So, regulatory reform is just aggravating a bad situation.
So, while the IPO market has problems of its own, one should never underestimate the importance of the general economy. “General economy” is a nice way to say “how people get by.” Make getting by dependent on government and sooner or later government runs out of rabbits in its hat. Further, governments, and for that matter, the media have problems with amorphous, self-contradictory, disorganized (maybe self-organizing) bunches of people. If amorphous, self-contradictory, disorganized or self-organizing doesn’t sound like how people get by, go out and talk to you neighbors, friends, relatives, and be sure to include some strangers.
Sunday, June 27, 2010
The discussion Congress should be having: PART 1 Angels, entrepreneurs, and diversification
Why the anemic recovery?
In case you didn’t notice, the US economy isn’t recovering from the recession anywhere near how it should. But, Congress doesn’t seem the least bit concerned. Rather, like the proverbial general, they’re trying to fight the last war. Elsewhere people are focusing on a sense that something’s wrong. Unfortunately, among the general public that may be no more than a fascination with today’s headline.
While our “leadership” is busy trying to find someone to blame, in certain areas people are seriously looking at what’s wrong even if it isn’t pretty and runs counter to popular fiction. To tap in on one very informative discussion, see “Tech IPO's: What TechCrunch & Fred Wilson Are Leaving Out” at Urgent Speed. It will direct you to a number of other relevant postings.
The discussion focuses on the sad state of the IPO market. It references a previous posting (Urgent Speed: Why Ten Million Dollar IPOs Matter: ). What’s unique about the discussion is that it goes beyond the sound bite single-cause-reporting so common in the media. Further, it has the added benefit of making some points that almost everyone else avoids. It lists nine contributing factors:
1. Death of the mid-market investment firms
2. Decimalization.
3. Rise of the Internet Brokerages
4. Growth of Prop Trading.
5. End of Equity Research.
6. Increased Litigation Risk
7. The Internationalization of Wealth.
8. Larger Global Funds.
9. Increased Regulatory Expense including Sarbanes-Oxley.
Too many people are inclined to make a global judgment about whether each point is and/or was desirable. They then put on blinders and refused to objectively assess ALL the consequences of the phenomena being discussed. They thereby relegate themselves to the status of useless advocates rather than constructive analysts.
Unexpected consequences are fairly common. What’s tragic about them is the conceit of our “leadership” that turns unintended consequences into unacknowledged consequences. It seems that acknowledging any unexpected consequences would call their omnipotent prescience into question. Their egos just can’t take it.
Interestingly, this weekend an article in the WALL STREET JOURNAL, “The Demise of the IPO—and Ideas on How to Revive It,” addressed the IPO issue. Although not directly citing the factors listed by Urgent Speed, the article acknowledged some of them by implication. As an example, it didn’t reference decimalization, rather it referenced a proposal for 10 cent trading increments. The article is worth reading. It can be found at: How to Fix the IPO Market - WSJ.com.
The Hedged Economist’s April 9th posting, The Hedged Economist: Angels, entrepreneurs, and diversification: PART 1, pointed out one aspect of our “leadership’s” contribution to a hostile environment for new ventures. But, the truth is the problem is deeply rooted in how we choose our leaders. It we don’t ask for evidence that they care about business, we shouldn’t be surprised if they don’t care. Even those who think everyone should work for government should insist that their leader at least understand business.
In case you didn’t notice, the US economy isn’t recovering from the recession anywhere near how it should. But, Congress doesn’t seem the least bit concerned. Rather, like the proverbial general, they’re trying to fight the last war. Elsewhere people are focusing on a sense that something’s wrong. Unfortunately, among the general public that may be no more than a fascination with today’s headline.
While our “leadership” is busy trying to find someone to blame, in certain areas people are seriously looking at what’s wrong even if it isn’t pretty and runs counter to popular fiction. To tap in on one very informative discussion, see “Tech IPO's: What TechCrunch & Fred Wilson Are Leaving Out” at Urgent Speed. It will direct you to a number of other relevant postings.
The discussion focuses on the sad state of the IPO market. It references a previous posting (Urgent Speed: Why Ten Million Dollar IPOs Matter: ). What’s unique about the discussion is that it goes beyond the sound bite single-cause-reporting so common in the media. Further, it has the added benefit of making some points that almost everyone else avoids. It lists nine contributing factors:
1. Death of the mid-market investment firms
2. Decimalization.
3. Rise of the Internet Brokerages
4. Growth of Prop Trading.
5. End of Equity Research.
6. Increased Litigation Risk
7. The Internationalization of Wealth.
8. Larger Global Funds.
9. Increased Regulatory Expense including Sarbanes-Oxley.
Too many people are inclined to make a global judgment about whether each point is and/or was desirable. They then put on blinders and refused to objectively assess ALL the consequences of the phenomena being discussed. They thereby relegate themselves to the status of useless advocates rather than constructive analysts.
Unexpected consequences are fairly common. What’s tragic about them is the conceit of our “leadership” that turns unintended consequences into unacknowledged consequences. It seems that acknowledging any unexpected consequences would call their omnipotent prescience into question. Their egos just can’t take it.
Interestingly, this weekend an article in the WALL STREET JOURNAL, “The Demise of the IPO—and Ideas on How to Revive It,” addressed the IPO issue. Although not directly citing the factors listed by Urgent Speed, the article acknowledged some of them by implication. As an example, it didn’t reference decimalization, rather it referenced a proposal for 10 cent trading increments. The article is worth reading. It can be found at: How to Fix the IPO Market - WSJ.com.
The Hedged Economist’s April 9th posting, The Hedged Economist: Angels, entrepreneurs, and diversification: PART 1, pointed out one aspect of our “leadership’s” contribution to a hostile environment for new ventures. But, the truth is the problem is deeply rooted in how we choose our leaders. It we don’t ask for evidence that they care about business, we shouldn’t be surprised if they don’t care. Even those who think everyone should work for government should insist that their leader at least understand business.
Friday, May 28, 2010
Fictitious liquidity
Now you see it; now you don’t
My last posting closed with “Neither liquidity nor transparency is a God, but there are aspects of both that are needed for markets to function.” Transparency was discussed in “The false God of transparency.” Now, it’s time to discuss liquidity. The definition is essential to understanding my use of “fictitious liquidity” in the posting on transparency. Further, it explains the rather counter intuitive reference to liquidity and volatility in the last posting. Since this is central to what has been said on this blog, this posting will address it in three ways: (1) textbook, (2) operational, and (3) practical.
For textbooks, let’s use INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT by Frank K. Reilly and Keith C. Brown as an example. After all, it is the textbook used to train many Certified Financial Analysts (CFAs) who become market participants. After discussing information, it defines liquidity as “… the ability to buy or sell an asset quickly and at a known price….”
It then goes on to define “price continuity” as a component of liquidity. It’s at that point that the discussion of liquidity gets telling. So, here’s the definition of price continuity “…that prices do not change much from one transaction to the next unless there is substantial new information available.” By making price continuity a component of liquidity, it ducks the question of whether information about liquidity is “substantial.”
That, as it turns out, is rather essential to the discussion of what liquidity is. Add price continuity, and one is no longer dealing with a concept. One is dealing with an objective. More importantly, from a behavioral perspective, liquidity becomes self-referential.
It also ignores the fact that money, for numerating trades, is not continuous. Is it saying “same price” in dollars, pennies, fractions of a penny?
It does say next trade; thus, defining time as whatever the market determines. That raises some questions: Is an asset liquid if it trades freely at the same price, but infrequently? Seems to me it could be boring, but liquid, but it could also be illiquid. Is the boring asset more liquid than an asset that turns over repeatedly each day but bounces around? Seems to me the textbook definition is just saying that it depends on how fast it bounces. It ducks the issue of clock time. As a consequence, it falls into the trap of implying instantaneous liquidity is necessary to liquidity. Liquidity has to address the issue of “by when” (i.e., time). Otherwise, the definition seems to be of little practical use.
Don’t get me wrong. I’m not disparaging what can be accomplished with continuous, instantaneous assumptions. Newton did some amazing things that advanced physics by working out how to use those assumptions. Besides calculus is fun for me; it creates an alternative universe all of its own. It has also facilitated some interesting and vital advances in finance and economics. But, eventually, one has to deal with the operational and practical.
The texts also incorporate the concept of depth. But, at this point we are really proceeding to what I’ve called the operational. Not surprisingly, it’s at this point the definition does get more substantive.
There is liquidity as in large pools of capital participating in the market. To my way of thinking, adding “a large numbers of counterparties” to the definition of liquidity without defining a legitimate counterparty makes the definition partially conditional. There is always some liquidity based on counterparties dependent on hedges. That generates counterparties without necessarily expanding the capital pool. It increases volumes that can be supported, but the increased volumes are ultimately based on leverage (i.e., larger volumes on the same capital base).
Arbitraging forward curve is a familiar illustration, but any form of statistical arbitrage or hedging strategy could do just as well. They illustrate the consequences of this fictitious liquidity. If the markets disconnect, the liquidity based on the arb can increase as the arbs place positions, but it can disappear if the hedge that allowed the leverage fails. In short, if the hedges fail, the difference between real and fictional liquidity surfaces. Thus, volumes only indicate liquidity under very specific conditions (i.e., if the hedges work). If my belief that there is no perfect hedge is correct, then failure is inevitable. It is this liquidity that I refer to as fictitious liquidity.
So, you ask: “Why is it fictitious? Just because it can go away, doesn’t mean it wasn’t real while it existed.” The issue of liquidity based on arbitrage or hedging isn’t new. It’s been discussed in the literature on financial markets. Terms like borrowed liquidity (i.e., liquidity borrowed across markets), and aggregated liquidity (i.e., combining the liquidity of two or more markets) have been applied. It has been celebrated as one of the breakthroughs of modern finance, and justifiably so. It increases the liquidity of each individual market.
Hedging and arbitrage would actually produce multiplicative liquidity if total liquidity were the sum of individual market liquidities. But, total liquidity isn’t the sum of individual market liquidities. Total liquidity would then be a product of total market activity. This is totally circular reasoning: liquidity makes trading possible and trading defines liquidity. That may be OK since the phenomena itself may be self-referential. But, the circular definition is one argument for calling it fictitious liquidity.
The liquidity could as easily be called leveraged liquidity. But, here’s where things get weird; to the extent hedges work, they cancel each other out. However, we have not canceled the liquidities across the markets. We accept that the liquidity is there as long as we believe it is there. Lose faith and unwind the hedge, and it is gone. So, I like fictitious.
“This is all terminology; how does it contribute to volatility?” One should remember the question about whether changes in liquidity are substantive information. That is the answer to how the usually stabilizing impact of liquidity can be destabilizing. Volatility isn’t about levels; it’s about change.
Economists are use to quasi self-referential systems. We talk of virtuous cycles and vicious cycles. But, economists, especially modelers, know that a specification that is self-referential can lead to an unstable or explosive model. One seeks to avoid models where the change in a variable is dependent on the level of the same variable or the change in the same variable, much less where the change in the rate of change is dependent on the change. The modeling solution is to build in mean reversion in some form or avoid self-referential specifications totally. That, however, doesn’t negate the fact that, to the extent liquidity is, in fact, self-referential, it produces a tendency toward instability (i.e., produces volatility).
Economists aren’t alone in having to deal with self-referential systems. In math, think chaos theory and fractals. For a pop culture example, think TIPPING POINT; HOW LITTLE THINGS CAN MAKE A BIG DIFFERENCE by Malcolm Gladwell, although it mixes in non-linear systems. Many disciplines (demographics, engineering, physics, evolutionary biology) have concluded self-referential systems tend to be volatile. So, we shouldn’t be too surprised if financial economics finds an example.
Now, let’s turn to the practical. In a practical sense, time is essential. For practical purposes, liquidity is the ability to move between assets when one wants. The assets may include money, often the focus of discussions of liquidity. Being able to move to the medium of general exchange extends the definition to include moving between investment and consumption. But, let’s leave the consumption/investment decision aside for now.
Once time is introduced, we need to have a practical definition of time. Time is never continuous in this context. Even at the nanosecond level it’s a bit on a computer. For someone trading fractions of a penny for fractions of a second, the units are very small. That’s fine if they’re basing it on the same information as other traders. However, if they’re trading between ticks, it gets downright dishonest. They remind me of the currency trader who took the ten thousandths of a penny dropped in accounting for foreign currency transactions, and deposited them in his bank account (he went to jail).
For other traders, seconds, minutes, hours, days, weeks, etc. are practical. For a person planning for retirement, multiple years could fit. A trade can be structured so that the practical definition is indefinite, good until canceled or executed, or good until unwound. Thus, a practical definition of time is very personal.
In practical time, price gaps (discontinuities) become a meaningless concept or just another way to say volatility. Once practical time is introduced, liquidity becomes the ability to exchange assets. Price disappears from the definition. That puts us at the mercy of supply and demand. What really exists is some number of buyers at each price and some number of sellers. Under this definition, buyers and sellers now define liquidity, but they will also determine price. Thus, by this definition, information about liquidity is “substantial.” So, under this definition liquidity is still self-referential and directly related to price.
This has implications for what people who retain the focus on price continuity mean. Essentially they’re saying they want the same price at transaction time as existed at some earlier point. There is no reason for the “same.” Buyers want lower; sellers want higher. There is also no reason for any specific time lapse. The more one is motivated to trade the shorter the time frame. It would seem the alternative definitions that incorporate price continuity are biased in favor of frequent trading. Since trading has a cost, it is legitimate to question the result from a capital allocation perspective.
Now a disclosure, I’m so comfortable with volatility that an observer might think I’m insensitive to its impact. I understand self-referential systems reasonably well, at least well enough to recognize one. But, that’s not insensitivity to the impact of the volatility produced by the self-referential nature of liquidity. The fictitious liquidity added to liquidity due to genuine counterparties (i.e., those willing to take a position in an asset) often adds to volatility. There is enough truth to the risk-equals-volatility logic to justify concern, especially since it influences the allocation of capital and even the capital formation verses consumption decision. I also recognize that many people don’t share my indifference. Further, some people are mislead into making bad investment decisions by their reactions to volatility. Other can trade it quite well.
Since volatility is a part of life, why single out inter-tick volatility (discontinuities) for special treatment. Gapping between ticks and between years is only different depending on whether the tick or the year is your trading time frame.
My last posting closed with “Neither liquidity nor transparency is a God, but there are aspects of both that are needed for markets to function.” Transparency was discussed in “The false God of transparency.” Now, it’s time to discuss liquidity. The definition is essential to understanding my use of “fictitious liquidity” in the posting on transparency. Further, it explains the rather counter intuitive reference to liquidity and volatility in the last posting. Since this is central to what has been said on this blog, this posting will address it in three ways: (1) textbook, (2) operational, and (3) practical.
For textbooks, let’s use INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT by Frank K. Reilly and Keith C. Brown as an example. After all, it is the textbook used to train many Certified Financial Analysts (CFAs) who become market participants. After discussing information, it defines liquidity as “… the ability to buy or sell an asset quickly and at a known price….”
It then goes on to define “price continuity” as a component of liquidity. It’s at that point that the discussion of liquidity gets telling. So, here’s the definition of price continuity “…that prices do not change much from one transaction to the next unless there is substantial new information available.” By making price continuity a component of liquidity, it ducks the question of whether information about liquidity is “substantial.”
That, as it turns out, is rather essential to the discussion of what liquidity is. Add price continuity, and one is no longer dealing with a concept. One is dealing with an objective. More importantly, from a behavioral perspective, liquidity becomes self-referential.
It also ignores the fact that money, for numerating trades, is not continuous. Is it saying “same price” in dollars, pennies, fractions of a penny?
It does say next trade; thus, defining time as whatever the market determines. That raises some questions: Is an asset liquid if it trades freely at the same price, but infrequently? Seems to me it could be boring, but liquid, but it could also be illiquid. Is the boring asset more liquid than an asset that turns over repeatedly each day but bounces around? Seems to me the textbook definition is just saying that it depends on how fast it bounces. It ducks the issue of clock time. As a consequence, it falls into the trap of implying instantaneous liquidity is necessary to liquidity. Liquidity has to address the issue of “by when” (i.e., time). Otherwise, the definition seems to be of little practical use.
Don’t get me wrong. I’m not disparaging what can be accomplished with continuous, instantaneous assumptions. Newton did some amazing things that advanced physics by working out how to use those assumptions. Besides calculus is fun for me; it creates an alternative universe all of its own. It has also facilitated some interesting and vital advances in finance and economics. But, eventually, one has to deal with the operational and practical.
The texts also incorporate the concept of depth. But, at this point we are really proceeding to what I’ve called the operational. Not surprisingly, it’s at this point the definition does get more substantive.
There is liquidity as in large pools of capital participating in the market. To my way of thinking, adding “a large numbers of counterparties” to the definition of liquidity without defining a legitimate counterparty makes the definition partially conditional. There is always some liquidity based on counterparties dependent on hedges. That generates counterparties without necessarily expanding the capital pool. It increases volumes that can be supported, but the increased volumes are ultimately based on leverage (i.e., larger volumes on the same capital base).
Arbitraging forward curve is a familiar illustration, but any form of statistical arbitrage or hedging strategy could do just as well. They illustrate the consequences of this fictitious liquidity. If the markets disconnect, the liquidity based on the arb can increase as the arbs place positions, but it can disappear if the hedge that allowed the leverage fails. In short, if the hedges fail, the difference between real and fictional liquidity surfaces. Thus, volumes only indicate liquidity under very specific conditions (i.e., if the hedges work). If my belief that there is no perfect hedge is correct, then failure is inevitable. It is this liquidity that I refer to as fictitious liquidity.
So, you ask: “Why is it fictitious? Just because it can go away, doesn’t mean it wasn’t real while it existed.” The issue of liquidity based on arbitrage or hedging isn’t new. It’s been discussed in the literature on financial markets. Terms like borrowed liquidity (i.e., liquidity borrowed across markets), and aggregated liquidity (i.e., combining the liquidity of two or more markets) have been applied. It has been celebrated as one of the breakthroughs of modern finance, and justifiably so. It increases the liquidity of each individual market.
Hedging and arbitrage would actually produce multiplicative liquidity if total liquidity were the sum of individual market liquidities. But, total liquidity isn’t the sum of individual market liquidities. Total liquidity would then be a product of total market activity. This is totally circular reasoning: liquidity makes trading possible and trading defines liquidity. That may be OK since the phenomena itself may be self-referential. But, the circular definition is one argument for calling it fictitious liquidity.
The liquidity could as easily be called leveraged liquidity. But, here’s where things get weird; to the extent hedges work, they cancel each other out. However, we have not canceled the liquidities across the markets. We accept that the liquidity is there as long as we believe it is there. Lose faith and unwind the hedge, and it is gone. So, I like fictitious.
“This is all terminology; how does it contribute to volatility?” One should remember the question about whether changes in liquidity are substantive information. That is the answer to how the usually stabilizing impact of liquidity can be destabilizing. Volatility isn’t about levels; it’s about change.
Economists are use to quasi self-referential systems. We talk of virtuous cycles and vicious cycles. But, economists, especially modelers, know that a specification that is self-referential can lead to an unstable or explosive model. One seeks to avoid models where the change in a variable is dependent on the level of the same variable or the change in the same variable, much less where the change in the rate of change is dependent on the change. The modeling solution is to build in mean reversion in some form or avoid self-referential specifications totally. That, however, doesn’t negate the fact that, to the extent liquidity is, in fact, self-referential, it produces a tendency toward instability (i.e., produces volatility).
Economists aren’t alone in having to deal with self-referential systems. In math, think chaos theory and fractals. For a pop culture example, think TIPPING POINT; HOW LITTLE THINGS CAN MAKE A BIG DIFFERENCE by Malcolm Gladwell, although it mixes in non-linear systems. Many disciplines (demographics, engineering, physics, evolutionary biology) have concluded self-referential systems tend to be volatile. So, we shouldn’t be too surprised if financial economics finds an example.
Now, let’s turn to the practical. In a practical sense, time is essential. For practical purposes, liquidity is the ability to move between assets when one wants. The assets may include money, often the focus of discussions of liquidity. Being able to move to the medium of general exchange extends the definition to include moving between investment and consumption. But, let’s leave the consumption/investment decision aside for now.
Once time is introduced, we need to have a practical definition of time. Time is never continuous in this context. Even at the nanosecond level it’s a bit on a computer. For someone trading fractions of a penny for fractions of a second, the units are very small. That’s fine if they’re basing it on the same information as other traders. However, if they’re trading between ticks, it gets downright dishonest. They remind me of the currency trader who took the ten thousandths of a penny dropped in accounting for foreign currency transactions, and deposited them in his bank account (he went to jail).
For other traders, seconds, minutes, hours, days, weeks, etc. are practical. For a person planning for retirement, multiple years could fit. A trade can be structured so that the practical definition is indefinite, good until canceled or executed, or good until unwound. Thus, a practical definition of time is very personal.
In practical time, price gaps (discontinuities) become a meaningless concept or just another way to say volatility. Once practical time is introduced, liquidity becomes the ability to exchange assets. Price disappears from the definition. That puts us at the mercy of supply and demand. What really exists is some number of buyers at each price and some number of sellers. Under this definition, buyers and sellers now define liquidity, but they will also determine price. Thus, by this definition, information about liquidity is “substantial.” So, under this definition liquidity is still self-referential and directly related to price.
This has implications for what people who retain the focus on price continuity mean. Essentially they’re saying they want the same price at transaction time as existed at some earlier point. There is no reason for the “same.” Buyers want lower; sellers want higher. There is also no reason for any specific time lapse. The more one is motivated to trade the shorter the time frame. It would seem the alternative definitions that incorporate price continuity are biased in favor of frequent trading. Since trading has a cost, it is legitimate to question the result from a capital allocation perspective.
Now a disclosure, I’m so comfortable with volatility that an observer might think I’m insensitive to its impact. I understand self-referential systems reasonably well, at least well enough to recognize one. But, that’s not insensitivity to the impact of the volatility produced by the self-referential nature of liquidity. The fictitious liquidity added to liquidity due to genuine counterparties (i.e., those willing to take a position in an asset) often adds to volatility. There is enough truth to the risk-equals-volatility logic to justify concern, especially since it influences the allocation of capital and even the capital formation verses consumption decision. I also recognize that many people don’t share my indifference. Further, some people are mislead into making bad investment decisions by their reactions to volatility. Other can trade it quite well.
Since volatility is a part of life, why single out inter-tick volatility (discontinuities) for special treatment. Gapping between ticks and between years is only different depending on whether the tick or the year is your trading time frame.
Sunday, May 23, 2010
Liquidity is dangerous
If I had a hammer, I’d hammer out danger, I’d hammer out a warning…With apologies to Peter Seeger & Lee Hays
The authors might take umbrage at using their lyrics (LYRICS - If I Had a Hammer) when discussing anything as crass as money. However, hopefully one doesn’t need a hammer to teach love between my brothers and my sisters. Maybe a bell and a song will do and they can lend me the hammer. It’s a little harder to teach a little financial common sense to powerful people with vested interests. Nevertheless, here’s some food for thought.
If, as the profs theorize, risk is price volatility and volatility requires liquidity, it is only a short hop to excess liquidity will produce excess volatility. But, volatility can be endured. There is a side argument that excess volatility discourages capital formation, producing a sub-optimal bias in favor of consumption -- an argument many profs overlook. But, that side argument isn’t what this posting is about. This posting is about a sub-optimal allocation of whatever capital there is. It seems I am not alone in noting that the blind pursuit of liquidity is compromising transparency and the market maker role of exchanges. I recommend reading " Stock Market Mayhem Confirms Need for Better Regulations - Barrons.com .
This is an excellent article. However, The Hedged Economist argued that the “flash crash” is not very mysterious (see: “The day the computers panicked” in PART 1 of a three part posting). Interestingly, I reached the same conclusion as the article about transparency and the blind pursuit of instantaneous and continuous liquidity (see: “The false God of transparency” the last posting). However, this blog broached the issue of how much liquidity is needed back on January 28 in “Efficient capital allocation doesn’t require perfect liquidity” in one of the first postings on this website.
Why the hammer? Because this is fast becoming a potential source of the next systemic meltdown. I can’t emphasize enough: efficient capital allocation doesn’t require perfect liquidity. It is time to add: efficient capital allocation can’t survive perfect liquidity if perfect liquidity requires sacrificing price transparency. Neither liquidity nor transparency is a God, but there are aspects of both that are needed for markets to function.
The authors might take umbrage at using their lyrics (LYRICS - If I Had a Hammer) when discussing anything as crass as money. However, hopefully one doesn’t need a hammer to teach love between my brothers and my sisters. Maybe a bell and a song will do and they can lend me the hammer. It’s a little harder to teach a little financial common sense to powerful people with vested interests. Nevertheless, here’s some food for thought.
If, as the profs theorize, risk is price volatility and volatility requires liquidity, it is only a short hop to excess liquidity will produce excess volatility. But, volatility can be endured. There is a side argument that excess volatility discourages capital formation, producing a sub-optimal bias in favor of consumption -- an argument many profs overlook. But, that side argument isn’t what this posting is about. This posting is about a sub-optimal allocation of whatever capital there is. It seems I am not alone in noting that the blind pursuit of liquidity is compromising transparency and the market maker role of exchanges. I recommend reading " Stock Market Mayhem Confirms Need for Better Regulations - Barrons.com .
This is an excellent article. However, The Hedged Economist argued that the “flash crash” is not very mysterious (see: “The day the computers panicked” in PART 1 of a three part posting). Interestingly, I reached the same conclusion as the article about transparency and the blind pursuit of instantaneous and continuous liquidity (see: “The false God of transparency” the last posting). However, this blog broached the issue of how much liquidity is needed back on January 28 in “Efficient capital allocation doesn’t require perfect liquidity” in one of the first postings on this website.
Why the hammer? Because this is fast becoming a potential source of the next systemic meltdown. I can’t emphasize enough: efficient capital allocation doesn’t require perfect liquidity. It is time to add: efficient capital allocation can’t survive perfect liquidity if perfect liquidity requires sacrificing price transparency. Neither liquidity nor transparency is a God, but there are aspects of both that are needed for markets to function.
Tuesday, May 18, 2010
The false God of transparency
Are we seeking wisdom, a voyeuristic look at secrets, or dirty laundry?
Transparency is one of those things that seems to be inherently good. But, that’s really a superficial attitude that is, fortunately, tempered by the application of common sense. It ignores a prime question: What should be shown? I certainly don’t want to see many of my friends nude, for example. It also ignores both privacy and intellectual property issues. That’s an acknowledgement from this blogger who is usually interested in what others are thinking. However, an even more interesting issue is: What will result from transparency? It’s a fascinating issue because people often don’t seem to have thought about it.
Let’s look at privacy first. We’ll use a headline issue: the GS and Paulson’s trade discussed in the two postings on how “Sometimes Wall Street provides more entertainment than Hollywood.” It is unfortunate that this example is so convenient because people get quite irrational when GS’s name comes up. But, forging ahead, we’ll set the topic with a quote from a NY Times piece entitled "From Buffett, Thought-Out Support for Goldman.” (full story at: http://www.nytimes.com/2010/05/04/business/04sorkin.html?scp=1&sq=from%20Buffet,%20thought-out%20support%20for%20goldman&st=cse )
“One Berkshire shareholder who has been a regular in Omaha is Bill Ackman, an outspoken hedge fund manager who has made a career of railing against bad corporate practices. … In recent days, he has gone even further than Mr. Buffett in his defense of Goldman, suggesting it would have been unethical for the firm to disclose Mr. Paulson’s position in the Abacus deal. He says that Goldman, as the market maker, had a duty to protect the identity of both sides of the transaction.”
Think about it this way: If it was ethical for GS to disclose Paulson's position, then it should be OK for your broker to disclose your positions to potential counterparties. Similarly, should GS have disclosed to Paulson who was taking the long position? Very analogous reasoning would argue that brokers should be allowed to disclose to potential counterparties that a mutual fund or pension fund plans to take a position in a stock; after all, Paulson had not, and could not have, taken his position until someone took the counterparty position. People have gone to jail for doing that sort of disclosure. It allows front running.
My only disclosure is that I have accounts with multiple brokers so that no single broker or dealer can disclose all my positions or even my net positions. It’s a by-product of differences in what each offers in tools and investments. But, many financial institutions use multiple dealers specifically to avoid having their positions disclosed by any one dealer. Your pension fund or mutual funds probably do exactly that.
If one tries to set parameters for when privacy should be sacrificed, it gets hairy real quick. Think about exchanges. Exchanges suppress all information about counterparties. Theoretically, one’s counterparty is the exchange. Should exchanges have to disclose their net positions? Could they even do it given the volume and speed of trading?
Many market observers hold the position that derivatives should be brought onto exchanges; I’m among them. If one shares that opinion about exchanges, but simultaneously say that GS should have disclosed that Paulson was shorting the bonds GS was selling, the observer isn’t being consistent. The observer is advocating suppressing the very information they’re saying should be disclosed. On an exchange that individual counterparty information is suppressed.
The same logical inconsistency exists whenever a person trades on an exchange (where they don’t have counterparty information) while simultaneously maintaining the counterparty should be disclosed. Do you know who your last few trades were with? Probably not.
Transparency is desirable if it involves the right information. Otherwise it is distracting and can have major negative consequences. To illustrate, both postings on how Wall Street can be more entertaining than Hollywood point out that neither the winners nor the losers felt that the motives of their counterparties were important. But, it is relevant, and perhaps not stressed enough, that most people involved either didn’t want their net positions disclosed or were worried by how much was publicly known about their net positions. In fact, some of the people who were net short mortgage bonds abandoned the trade because they feared a short squeeze. The issue of short squeezes is a point often overlooked in the discussions of transparency.
However, the really dangerous oversight from the perspective of financial stability is the failure to address what should be transparent. The motive of the counterparty is not really relevant. If it were, exchanges would be irrelevant. What matters are: (1) Is the counterparty solvent (i.e., can the counterparty make good on the trade)? and (2) Is the trade at a legitimate market price?
Why is this dangerous from a systemic risk perspective? Exchanges face conflicting objectives. They were mention in a previous posting on this blog. They are sufficiently central to this point that the discussion is quoted below:
“The issue surfaced in an exchange between Duncan Niederauer, CEO NYSE Euronext, and Bob Greifeld, CEO Nasdaq OMX Group Inc. Greifeld’s contention is that the overall volatility in the stock was increased by the Nasdaq’s inability to provide enough liquidity to accommodate an orderly handling of the volatility. He doesn’t say it that way since blaming it on the NYSE is so much more consistent with his interests. But, that’s the bottom line of his position. That seems reasonable. When all the volatility risk is shifted to one market, that market will be stressed.
Niederauer’s counter that the purpose of the NYSE is to provide an orderly market. Can’t argue with that. But, under the circumstances he seems to be overly professional in not pointing out that Nasdaq didn’t deliver an orderly market.
Here’s where the verbal exchange gets interesting, and it betrays each man’s philosophy and the market they serve. Another function of an exchange is to provide liquidity. Clearly, when the NYSE moved to slow mode it traded off providing instant liquidity for orderly market. Who is served by each? People don’t even sense instant liquidity. The slower mode and even a pause for a few minutes would hardly be noticed. By contrast, computers assume instantaneous, continuous liquidity. Put bluntly, Nasdaq would accommodate computers at the expense of people while NYSE leaned the other direction.
Next step in the analysis involves the exchange’s role as a method of price discovery. Clearly, that is a key function of an exchange. Again, Nasdaq was willing to “execute” any trade without regard to whether the price discovery was being compromised in order to accommodate continuous trading. NYSE wasn’t. If one needs proof, it will come when trades are unwound as is being discussed.
Finally, an exchange acts as a clearing house becoming the counterparty. NYSE slowed trading to ensure it could fill that counterparty role. We will see whether Nasdaq honors all trades. This last issue goes to the heart of the issue of whether an exchange walked away from the market. Slowing trading isn’t walking away from the market; it’s slowing it. By contrast executing erroneous trades and then not honoring them is walking away from at least two important responsibilities of an exchange.”
The exchanges are clearly trading off providing liquidity, providing an orderly market, supporting price discovery, and acting as counterparty. Now, ask yourself which is important from the perspective of investors. My vote goes to supporting price discovery. If the price quoted on the exchange is not a market price available to every potential trader, risk takes on an additional dimension. What good are all the other disclosures if one doesn’t really know what the price is?
The argument that acting as counterparty is most important can’t be dismissed. After all, a rapid, radical shift in assessments of counterparty risk was a prime cause of the 2007-2009 financial crisis. Also, acting as counterparty eliminates any real liquidity issue if there is honest price discovery. The flash crash resulted from a fictitious liquidity created by the development of trading systems without real counterparties. So, the clearinghouse function is right up there, especially as it relates to systemic risk.
The problem is that exchanges are compromising the most important forms of transparency: price. Flash trading involves not just allowing trades at prices other than quoted prices, but is close to offering different prices on a selective basis. If selected traders are allowed access to inside information about market internals, they have an opportunity, and some would say are encouraged, to trade at other than quoted prices. This subverts basic transparency.
Similarly, dark pools, where stocks trade off of the markets, raise the same issue. If the price in the market isn’t the price at which the stock is being traded, transparency is a fiction. Again, who cares why the stock changes hands when the price at which it trades isn’t really the price?
So, it seems discussions of transparency should always be prefaced by the question: What is going to be made apparent? It also seems that the SEC and the investing public need to think about what transparency is important.
Addendum:
One could argue that liquidity is a necessary condition for price discovery. The trader would ask: What relevancy is a price quote if nothing can be traded at that price? The fund manager would say: The price isn’t valid for the volumes the fund trades. The Doc would add: There is no market without liquidity. But, that seems to be basic economics. Supply curves and demand curves have slopes. Given prices in digits and fractional shares, how much of the demand curve and the supply curve could be disclosed?
It seems with volumes and prices a lot about liquidity is already known. Bid ask spreads and/or price fluctuations over whatever time frame is assumed in one's definition of liquid, are known. Thus, historical liquidity is disclosed. Future liquidity and instantaneous liquidity are nice concepts, but not a reality. However, if blocks are traded without disclosure (i.e., in dark pools), then neither liquidity nor price are being disclosed.
Transparency is one of those things that seems to be inherently good. But, that’s really a superficial attitude that is, fortunately, tempered by the application of common sense. It ignores a prime question: What should be shown? I certainly don’t want to see many of my friends nude, for example. It also ignores both privacy and intellectual property issues. That’s an acknowledgement from this blogger who is usually interested in what others are thinking. However, an even more interesting issue is: What will result from transparency? It’s a fascinating issue because people often don’t seem to have thought about it.
Let’s look at privacy first. We’ll use a headline issue: the GS and Paulson’s trade discussed in the two postings on how “Sometimes Wall Street provides more entertainment than Hollywood.” It is unfortunate that this example is so convenient because people get quite irrational when GS’s name comes up. But, forging ahead, we’ll set the topic with a quote from a NY Times piece entitled "From Buffett, Thought-Out Support for Goldman.” (full story at: http://www.nytimes.com/2010/05/04/business/04sorkin.html?scp=1&sq=from%20Buffet,%20thought-out%20support%20for%20goldman&st=cse )
“One Berkshire shareholder who has been a regular in Omaha is Bill Ackman, an outspoken hedge fund manager who has made a career of railing against bad corporate practices. … In recent days, he has gone even further than Mr. Buffett in his defense of Goldman, suggesting it would have been unethical for the firm to disclose Mr. Paulson’s position in the Abacus deal. He says that Goldman, as the market maker, had a duty to protect the identity of both sides of the transaction.”
Think about it this way: If it was ethical for GS to disclose Paulson's position, then it should be OK for your broker to disclose your positions to potential counterparties. Similarly, should GS have disclosed to Paulson who was taking the long position? Very analogous reasoning would argue that brokers should be allowed to disclose to potential counterparties that a mutual fund or pension fund plans to take a position in a stock; after all, Paulson had not, and could not have, taken his position until someone took the counterparty position. People have gone to jail for doing that sort of disclosure. It allows front running.
My only disclosure is that I have accounts with multiple brokers so that no single broker or dealer can disclose all my positions or even my net positions. It’s a by-product of differences in what each offers in tools and investments. But, many financial institutions use multiple dealers specifically to avoid having their positions disclosed by any one dealer. Your pension fund or mutual funds probably do exactly that.
If one tries to set parameters for when privacy should be sacrificed, it gets hairy real quick. Think about exchanges. Exchanges suppress all information about counterparties. Theoretically, one’s counterparty is the exchange. Should exchanges have to disclose their net positions? Could they even do it given the volume and speed of trading?
Many market observers hold the position that derivatives should be brought onto exchanges; I’m among them. If one shares that opinion about exchanges, but simultaneously say that GS should have disclosed that Paulson was shorting the bonds GS was selling, the observer isn’t being consistent. The observer is advocating suppressing the very information they’re saying should be disclosed. On an exchange that individual counterparty information is suppressed.
The same logical inconsistency exists whenever a person trades on an exchange (where they don’t have counterparty information) while simultaneously maintaining the counterparty should be disclosed. Do you know who your last few trades were with? Probably not.
Transparency is desirable if it involves the right information. Otherwise it is distracting and can have major negative consequences. To illustrate, both postings on how Wall Street can be more entertaining than Hollywood point out that neither the winners nor the losers felt that the motives of their counterparties were important. But, it is relevant, and perhaps not stressed enough, that most people involved either didn’t want their net positions disclosed or were worried by how much was publicly known about their net positions. In fact, some of the people who were net short mortgage bonds abandoned the trade because they feared a short squeeze. The issue of short squeezes is a point often overlooked in the discussions of transparency.
However, the really dangerous oversight from the perspective of financial stability is the failure to address what should be transparent. The motive of the counterparty is not really relevant. If it were, exchanges would be irrelevant. What matters are: (1) Is the counterparty solvent (i.e., can the counterparty make good on the trade)? and (2) Is the trade at a legitimate market price?
Why is this dangerous from a systemic risk perspective? Exchanges face conflicting objectives. They were mention in a previous posting on this blog. They are sufficiently central to this point that the discussion is quoted below:
“The issue surfaced in an exchange between Duncan Niederauer, CEO NYSE Euronext, and Bob Greifeld, CEO Nasdaq OMX Group Inc. Greifeld’s contention is that the overall volatility in the stock was increased by the Nasdaq’s inability to provide enough liquidity to accommodate an orderly handling of the volatility. He doesn’t say it that way since blaming it on the NYSE is so much more consistent with his interests. But, that’s the bottom line of his position. That seems reasonable. When all the volatility risk is shifted to one market, that market will be stressed.
Niederauer’s counter that the purpose of the NYSE is to provide an orderly market. Can’t argue with that. But, under the circumstances he seems to be overly professional in not pointing out that Nasdaq didn’t deliver an orderly market.
Here’s where the verbal exchange gets interesting, and it betrays each man’s philosophy and the market they serve. Another function of an exchange is to provide liquidity. Clearly, when the NYSE moved to slow mode it traded off providing instant liquidity for orderly market. Who is served by each? People don’t even sense instant liquidity. The slower mode and even a pause for a few minutes would hardly be noticed. By contrast, computers assume instantaneous, continuous liquidity. Put bluntly, Nasdaq would accommodate computers at the expense of people while NYSE leaned the other direction.
Next step in the analysis involves the exchange’s role as a method of price discovery. Clearly, that is a key function of an exchange. Again, Nasdaq was willing to “execute” any trade without regard to whether the price discovery was being compromised in order to accommodate continuous trading. NYSE wasn’t. If one needs proof, it will come when trades are unwound as is being discussed.
Finally, an exchange acts as a clearing house becoming the counterparty. NYSE slowed trading to ensure it could fill that counterparty role. We will see whether Nasdaq honors all trades. This last issue goes to the heart of the issue of whether an exchange walked away from the market. Slowing trading isn’t walking away from the market; it’s slowing it. By contrast executing erroneous trades and then not honoring them is walking away from at least two important responsibilities of an exchange.”
The exchanges are clearly trading off providing liquidity, providing an orderly market, supporting price discovery, and acting as counterparty. Now, ask yourself which is important from the perspective of investors. My vote goes to supporting price discovery. If the price quoted on the exchange is not a market price available to every potential trader, risk takes on an additional dimension. What good are all the other disclosures if one doesn’t really know what the price is?
The argument that acting as counterparty is most important can’t be dismissed. After all, a rapid, radical shift in assessments of counterparty risk was a prime cause of the 2007-2009 financial crisis. Also, acting as counterparty eliminates any real liquidity issue if there is honest price discovery. The flash crash resulted from a fictitious liquidity created by the development of trading systems without real counterparties. So, the clearinghouse function is right up there, especially as it relates to systemic risk.
The problem is that exchanges are compromising the most important forms of transparency: price. Flash trading involves not just allowing trades at prices other than quoted prices, but is close to offering different prices on a selective basis. If selected traders are allowed access to inside information about market internals, they have an opportunity, and some would say are encouraged, to trade at other than quoted prices. This subverts basic transparency.
Similarly, dark pools, where stocks trade off of the markets, raise the same issue. If the price in the market isn’t the price at which the stock is being traded, transparency is a fiction. Again, who cares why the stock changes hands when the price at which it trades isn’t really the price?
So, it seems discussions of transparency should always be prefaced by the question: What is going to be made apparent? It also seems that the SEC and the investing public need to think about what transparency is important.
Addendum:
One could argue that liquidity is a necessary condition for price discovery. The trader would ask: What relevancy is a price quote if nothing can be traded at that price? The fund manager would say: The price isn’t valid for the volumes the fund trades. The Doc would add: There is no market without liquidity. But, that seems to be basic economics. Supply curves and demand curves have slopes. Given prices in digits and fractional shares, how much of the demand curve and the supply curve could be disclosed?
It seems with volumes and prices a lot about liquidity is already known. Bid ask spreads and/or price fluctuations over whatever time frame is assumed in one's definition of liquid, are known. Thus, historical liquidity is disclosed. Future liquidity and instantaneous liquidity are nice concepts, but not a reality. However, if blocks are traded without disclosure (i.e., in dark pools), then neither liquidity nor price are being disclosed.
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