One of the arguments apparently being made in Washington by those who oppose regulation of credit default swaps is that it would reduce liquidity and that of course would be a terrible thing.
My impression is that no one has endeavored to put metrics on this assertion (as in how and where liquidity would be reduced and what the consequences would be). However, just because a certain amount of liquidity is good, it does not necessarily follow that more is always better. Recall Keynes’ remark, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done.” Excessive liquidity can lead to precisely such an outcome. (Note we recently discussed evidence of harm caused by CDS, and asked readers for examples of where they were beneficial, and what sort of transactions required customization. The response was underwhelming).
We are suffering a hangover from just such a period. One of the comments I have heard from debt market participants in the bubble era was that they were faced with a ‘wall of liquidity”, tons of money looking for places to park it. And some of that appeared to be the direct result of credit default swaps. CDS allowed banks in Europe to circumvent capital requirements, enabled investment banks to accelerate profits from deals into the current period by (in theory) defeasing risk, allowed banks to extend bigger loans than they would have otherwise by hedging some of the risk. The net effect was that a lot of players achieved higher gearing than they would have otherwise.
Another effect of high liquidity is to lower bid-ask spreads. Until recently, greater efficiency (which is what you get with lower transaction costs) is seen as a boon. But lower transaction costs also fuel speculative activity. Behavioral finance studies have found that even in simple bidding setting, participants create bubbles. Low transaction costs and the appearance of abundant liquidity supports short-term, momentum based trading strategies, with participants believing they can find the exits when they need to (recall former Citi CEO Chuck Prince’s infamous “still dancing” remark). Higher frictional costs lead investors to think twice about adding and exiting positions.
Reader thought on this issue are encouraged. How does one judge when liquidity has become excessive, when the ease of trading starts to distort fundamental activity, or adjacent markets? Or is it like pornography, difficult to define objectively, but easy to identify?
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James Howard Kunstler said it well: “The road to hell is paved with efficiency.”
While I don’t know where to quantify exactly how much fugitive capital is “too much”, I do know insanity when I see it.
What could be more insane than this compulsion to always increase the amount of liquidity sloshing around, even as investors become ever more desperate to find places to put it, to the point that they have to blow up crazy bubbles in the FIRE sector (which, in any rational economy would be an epiphenomenon of actual productive activity)? It really is a craziness akin to crack addiction.
Evolution does not favor the hyper-“efficient” speed freak just-in-time zero-room-for-error model. Even without the malefic influence of man, the cheetah looks like a failing model, while the lion is a winner.
One of the basic principles for the restoration of civilization is that we shun the “efficiency” mythology in favor of common sense human principles of resiliency, robustness, redundancy.
For example, for breaking the liquidity binge mentality, we need to quickly head back toward 100% reserve requirements.
i’d favor margin/leverage requirements.
while there are no hard and fast thresholds for them, there are historical norms. for instance consumer debt being no more than 33% of income, banks having leverage ratios less than 12%, etc.
i’ve always felt that it’s not the problem of innovation per se, but the abuse of leverage in using them.
A market is a negative-feedback regulated system. As the gain (amplification ratio) around the loop through such a system and its feedback path is increased, a point will be reached at which the system becomes unstable and begins first to “ring” in response to upsets.
Further increasing in the gain will cause the system to begin to respond to an upset by breaking into oscillations whose amplitude increases rapidly until they either are limited by external constraints, or destroy the system.
The reason for this is that in all real-world systems there are lags and pure delays around the loop such that the feedback signal is time-shifted an amount which at some signal frequency equals a 180-degree phase shift, changing the feedback at that frequency from stabilizing negative feedback to destabilizing positive feedback.
Because of this, feedback-stabilized systems must be engineered such that the loop gain is less than unity at the 180-degree phase shift frequency. This is a Control Engineering 101 topic.
Many of the putatively desirable financial innovations so touted by Wall Street and certain economists have had the effect of increasing loop gain. It is therefore not at all surprising to anyone who has any control engineering background and perceives that fact that the system was sent into a violently unstable state by an upset many dismissed as of minor magnitude. That’s just how feedback-regulated systems behave when you don’t constrain their loop gain.
“How does one judge when liquidity has become excessive, when the ease of trading starts to distort fundamental activity, or adjacent markets?”
Control engineers and technicians tune loop gain so as to avoid destructive oscillation by initially setting it low, then carefully (i.e., slowly) increasing it while observing the process response to upsets. The exact “initial low setting” may be based on practical experience with similar systems; if practical experience is lacking, and it’s not feasible to intentionally “bump” the system to observe its response, the initial setting and rate of increase must be especially conservative.
Yves: “Behavioral finance studies have found that even in simple bidding setting, participants create bubbles.” Exactly. Bubbles are _inherent_ in open asset exchange markets. The first issue when liquidity is provided to markets for any overall regulator, should and must be, “How do we prevent asset overpricing as a consequence? “
Regarding ‘how much liquidity is too much,’ there are at the simplest two levels to look at. One is at the scale of the individual node/actor, the other is across an asset class as a whole. The liquidy of individual nodes MUST be constrained as an inherent function of financial regulation. I’m of the view, however, that this should scale in rather than be a fixed number, raising the costs to any individual collateral-based actor at each higher level of credit usage, regardless of how well existing debt is being surfaced.
At asset class wide levels, it has to be driven through the thick head of the speculattion-loving public that what goes up does fall down. _Rapid increase_ of asset prices is inherently destabilizing. One way to suppress that is through scaling in of transaction costs, and that specifically includes suppressive levels of taxation for windfall increase speculative asset surges. Another way to assess whether systemically liquidity has reached truly dangerous levels is whether price surges flow lateraly as one speculative vector is constrained. Any one asset class may have substantive reasons for abrupt spikes in values, ones that can be and are analyzed. If when constrained speculative liquidity begins to pump up the volume elsewhere, there is simply too much pseudo-money in motion.
I think low transactional costs facilitate high frequency trading, which is destabilizing.
I’d like to reduce the high frequency trading by quants and humans at GS, Highbridge, etc with a 2% tax on the gross proceeds of sales of assets with a holding period of 48 hours or less. And no exception for proprietary trades by broker or dealers.
Low transaction costs obviously aren’t the only issue though. We need restrictions on leverage, prohibition of off-balance sheet financing (so, e.g., a company with derivatives exposure can’t just show cash collateral on its balance sheet), booking MTM profits (so, e.g., a broker can’t book profits from a purportedly hedged trade up front, like Enron used to), leverage limits on derivatives, through margin requirements or reserve requirements.
You might be reading too deeply into this, or not from the right angle. Looking at Keynes quote, it would seem better to look at the financial system as simply a means to facilitate the “real” economy.
The question then becomes what sort of financial system do you need to make the wheels go around and that means tying money, and particularly its growth, to the real economy.
There’s some real easy things to be done here, all of which will make Wall Street squeal like stuck pigs, just as they did in the 30s. Go back and look at the wailing and writhing on how the establishment of the SEC was the end of capitalism.
A couple things easy are reserve requirements for all money “instruments.” Separation of money, you know Glass-Steagall, so that you keep more stable conservative elements of the economy, like housing, separate from the more speculative elements. You put walls into the money supply, so that it doesn’t all go up and down at the same time. Laws against usury. Limits on making money on money, as opposed to making money by making stuff. Again this is easy, it works.
Getting rid of derivatives, blowing up securitization and all the other financial innovations, that will be hard.
Or we can reverse engineer. How about this number, back in late 50s and 60s the financial industry accounted for less than 10% of corporate profits in a very robust American economy, in 2006 it was up to 31%. So, how much liquidity is too much, about 2/3 of what we had at the bubble’s greatest girth.
In short, I think you have to first ask what do we want to do with our real economy, and then secondly, what does the currency/financial system look like that facilitates that. Yet, any change at all is going to make Wall Street scream murder.
It’s very hard at this point to see where this all goes. We haven’t even begun a real discussion on any of this, Wall Street remains completely dominant.
James,
I would continue your feedback control theory example and extend it to phase shift. If there is too much time lag between when the negative feedback is enforced, that is another element that leads to instability. It was present in the huge bonuses today while taking huge risks tomorrow.
Liquidity is desirable when a position needs to be entered or exited quickly. Hedges qualify, but its close cousin insurance do not. Thus enters moral hazard and regulation.
Insurance is written in short duration, so that holding the paper to maturity is inexpensive enough to not require liquidity. But houses and bodies are long term assets, and so (theoretically) are hedgable loans.
Short contract insurance is not perfect either. If I get cancer, my insurance company would prefer not to renew, but I have a legal long term option.
So, in leiu of liquidity, we have regulation.
Given the object lesson we are all getting in moral hazard and oligopoly’s, this is probably the best option.
Joe @ 12:20PM: Eloquently stated. It is difficult to broach the idea of appropriate limits to speculative activity especially among the types of folks who frequent trader-oriented blogs. I am not intimately familiar with the higher eschelons of finance, but I'm not sure you have to be to know that when the majority of trading activity on the NYSE is done by short-term quant and arbitrage strategies, we're not really facilitating "capitalism" or true "growth".
I've been hoping to stumble across an intelligent discussion of exactly this topic (the assumption that more liquidity == good) and here it is. Thanks Yves & all for a great thread.
I find it ironic that the same people saying NOT to regulate CDS because of liquidity are the same ones that would never want them standardized or traded on an exchange where things would really be liquid (including margin calls and such).
There is a natural liquidity which is good, but the fake kind – mainly leverage but including other things – is where things get into trouble.
The extra credit drives prices down at first, but when something reverses and everyone tries to head for the exits, liquidity disappears.
4 years with 400% liquidity and one year with 0% doesn’t average to 320% liquidity – it is a bubble and a crash.
What is needed is continuous liquidity, and to have that maximized.
Reserve requirements and liquidity ought not be confused.
If money = liquidity and our money is debt-based, then the problem becomes the regulation of debt in the system. Debt is akin to leverage, and once the levels of debt in an economy become too great, the burden of debt service begins to drain the real economy of its wealth.
Debt is not going to go away. Neither is leverage. But we can make the system healthy by eliminating moral hazard. Letting companies fail is healthy. All derivatives must be regulated as they are in futures markets, by strict margin requirements. There is no need for leverage greater than 10:1. Margin requirements for debt-based paper-based derivatives like bonds, stocks, or currencies could be 2x greater than for physical commodities, since they are potentially subject to greater discontinuities (runs, crashes).
Off-balance sheet accounting must be eliminated to properly assess capital bases for calculating margin requirements. Gold, grains, oil, etc could suffice as acceptable collateral for margin instead of debt. Theoretically, we could have a stable fiat currency regime, but we have demonstrated we are not yet disciplined enough to not go off the rails. Commodity-backed “hard” currencies enforce market discipline.
As a futures trader, I object to onerous taxation of short-term transactions. Traders and market makers are necessary to spread risk effectively. Futures markets arose spontaneously centuries ago as a legitimate response to real-world inventory management problems and the cyclical nature of weather and crop conditions. Taxing liquidity will only disrupt market functions. It is a backward solution to the problem. The solution is to moderate and regulate systemic levels of debt — in other words, to rein in the banksters.
Given the present political climate and the death grip the banksters have on the government, this may require a crash of the financial system.
Please Greg unconfuse
So sandorgb, your point regarding controlling systemic debt is a good one in principle. If I had the option of limiting debt in a financial system first or limiting liquidity, I would certainly prefer to limit debt. But doing so does not remove the inherent instability of having too much credit flying around a system. Consider the analogy: one can capsize a boat by a single 30:1 person stepping on the beam to board if it is already dangerously overloaded. Or one can capsize it by having 30 1-value folks step on board because the buoyancy of the vessal simply isn’t stable in an upright position with that much mass regardless of where it is distributed, or how. Sheer volume is a real problem in and of itself apart from its contracual relationship with balancing collateral. With regard to prices, too much liquidity will float prices excessively; that’s going to happen.
Regarding whether transaction taxes are the way to go, that’s only one suggestion, and an unpretty but highly frictional and so effective brake. At some point, and effective buffer to effective liquidity makes it necessary that either an entiry is 100% disincentivized to exceed the trigger, simply told “No, you can’t,” which requires such tremendous resource commitment to monitoring as to be improbable, or 100% collateralized. Your suggestion that collateral and margin requirements be raised rather than tax ‘brakes’ applied is good. Myself, I would like both: collateral rises and scale-in tax increases above certain levels.
And off-balance sheet activities _should_ have been illegal, so the will to regulate is critical, there. We will face future instances where the regulator is weak-willed, which is why having passive statutory ‘brakes’ in place which do not require active implementation by regulators is an important component of any solution. The removal of Glass-Stegal was in effect, a disconnection of the breakes in the vehicle of the economy. I thought it was madness at the time, and a crack-up followed as was near certain.
“Higher frictional costs lead investors to think twice about adding and exiting positions.”
Frictional costs is a key word here. I’ve made the analogy myself of the current system to a car without shock absorbers. Dampers are an important part of stabilizing tightly coupled systems.
Markets seek towards equilibrium like a pendulum. We should add dampers and the equilibrium might some day be reached, and not just passed on the way to the other extreme.
The social justification for capital markets is to provide real capital for real economic activity.
Is there any social benefit by creating synthetic bonds? Not much. Was there a single synthetic CDO that made money?
Is the purpose of our educational system to provide jobs for teachers and administrators? The only way to make any sense in education is to attempt to make decisions that are focused on the needs of children.
The rationale for capital markets is to facilitate allocation of capital and the burden of proof that financial instruments are socially beneficial should fall on those that create them.
I think we are stuck with complex derivatives and they will be traded in jurisdictions that are lightly regulated.
However, there is no reason that highly regulated and frequently subsidized entities (Pension Funds, Commercial Banks) can’t be limited or walled off.
It always seemed idiotic to me that Pension funds were being sold portable alpha strategies and Municipalities complex swaps.
Isn’t the main point of this post that “gambling” can be destabilizing and that liquidity provides more opportunities to gamble? It’s the gambling that needs to be regulated, not necessarily the liquidity. We can talk about nonrecourse and “judgment proof” bets all we want, but gambling is inherent in the human condition because we all have a small statistical sample in that we have one life. It’s logical to bet it all if the only thing you want is to live the life of a masteroftheuniverse rather than just bottom feed as a slumdog your whole life. The gambling is what needs to be regulated. This seems obvious to me, but maybe I’m just a socialist (just kidding).