Nothing illustrates more starkly the difference between the preoccupations of financial market participants and the needs of businesses and households than the subject of liquidity.
Last week the Bank of England held an open forum to discuss what the financial sector contributes to the real economy, and I took part in a discussion on the role of liquidity. It began from a practitioner’s definition of liquidity: “The ease with which one asset can be exchanged for another.” Finance professionals bemoaned a decline in liquidity, blaming the global crisis and the subsequent intensification of regulation. In markets such as corporate bonds, they reported almost no liquidity at all.
But while the ease of exchanging one asset for another matters to traders, that is not the measure of liquidity that matters to savers. For them, security of their cash is crucial; they want to be able to take their money out of banks when they need it and they need to be sure that ATMs will continue to function.
Savers also need to be able to realise their assets in retirement and for big purchases. But they do not need a stock exchange in which shares are traded every millisecond. Their needs would be met adequately by a market that opened once a week. Perhaps once a month, or once a year, would do.
So focusing on the needs of savers and business rather than market participants leads to a different perspective on liquidity. Corporate bonds are long-term company obligations, mostly held by insurance companies and pension funds to meet their own long-term obligations. There is not much trade or liquidity in these markets because there is not much need for trade or liquidity in these securities.
The practitioners at the open forum worried that the absence of an active market damaged the process of “price discovery”. But “price discovery” seems to mean something different from “value discovery”, which is an estimate of the expected cash flows that holders will derive from the security over its life. “Price discovery” owes more to other traders’ expectations than fundamentals of valuation. To believe more can be learnt about the credit quality of a bond by stimulating trade in it than from careful evaluation of the circumstances of the issuer requires an unjustified faith in the “wisdom of crowds”. A lesson of the subprime mortgage fiasco is that an active market in securitised products is no substitute for careful assessment of the borrower’s capacity to repay.
Regulation of unit trusts and other open-ended investment products, and of insurance and pension funds, today imposes requirements for marketability far in excess of anything required by the underlying needs of savers. And the restrictions these obligations impose on investment choices damage the interests of the retail customers whom the rules were initially intended to help.
Regulators then fear savers might actually use the liquidity they are promised, but do not really need, by massive withdrawals from a single asset manager in which they have lost confidence. This fear is the basis of an argument for yet further regulation, involving the designation of large asset managers as “systemically important financial institutions”. And so the spiral of increasing regulatory complexity winds on.
Liquidity in financial markets is often equated to the volume of trade. But every financial crisis shows that such liquidity is liable to evaporate when actually required. An assurance that the funding requirements of businesses and households can be met is best achieved by a resilient, well-capitalised banking system and an asset-management sector focused on the long-term needs of both providers and users of capital. A market characterised by large trading volumes on low spreads serves the interests of market practitioners rather than their customers.
This article was first published in the Financial Times on October 18th, 2015.
