{"id":104,"date":"2015-08-14T19:44:09","date_gmt":"2015-08-15T00:44:09","guid":{"rendered":"https:\/\/sites.bu.edu\/perry\/?p=104"},"modified":"2019-01-17T14:29:49","modified_gmt":"2019-01-17T19:29:49","slug":"the-fuss-about-market-liquidity","status":"publish","type":"post","link":"https:\/\/sites.bu.edu\/perry\/2015\/08\/14\/the-fuss-about-market-liquidity\/","title":{"rendered":"The Fuss about Market Liquidity"},"content":{"rendered":"

The recently released PwC\u00a0“Global Financial Markets Liquidity Study”,<\/a>\u00a0sounds a warning. \u00a0Financial regulation, while perhaps well-intentioned, has gone too far. \u00a0Banks may be safer but markets are more fragile.<\/p>\n

At the moment, this fragility is masked by the massive liquidity operations of world central banks. \u00a0But it will soon be revealed as, led by the Fed, central banks attempt to exit. \u00a0Now, before it is too late, additional regulatory measures under consideration should be halted (Ch. 5). \u00a0And existing regulations should be urgently revisited with an eye to achieving better balance between two social goods, financial stability and market liquidity, rather than the current focus on stability at the expense of liquidity (Ch. 3).<\/p>\n

The bulk of the report consists of market-by-market empirical documentation of the reduction in market liquidity in past years (Chapter 4, pp. 51-104). \u00a0Pretty much all markets have been affected, even sovereign bond markets, but especially markets that were already not so liquid. \u00a0“There is clear evidence of a reduction in financial markets liquidity, particularly for less liquid areas of the financial markets, such as small and high-yield bond issues, longer-term FX forwards and interest rate derivatives. However, even relatively more liquid markets are experiencing declining depth, for example US and European sovereign and corporate bonds” (p. 104)<\/p>\n

“Bifurcation”, meaning widening difference between vanilla markets now supported by central clearing and everything else, is a repeated watchword, as well as “liquidity fragmentation” across different jurisdictions. \u00a0Both are taken to be obvious bads. \u00a0But are they?<\/p>\n

The central analytical frame of the report is that market liquidity is always and everywhere a good thing, and that more of it is always and everywhere better than less. \u00a0“We consider market liquidity to be invariably beneficial<\/strong>” (p. 8, 17). \u00a0“We consider market liquidity to be beneficial in both normal times and times of stress. For this study we therefore work on the premise that market liquidity is invariably beneficial” (p. 23). \u00a0Accept this premise, and everything else follows. \u00a0But why accept the premise?<\/p>\n

To be sure, economics quite regularly adopts the simplifying assumption that all markets are fully liquid, so that supply always exactly equals demand and markets always clear. \u00a0(On page 17, the report cites the venerable Varian microeconomics text as authority.) \u00a0It’s a good assumption if you are concerned about something other than market liquidity. \u00a0It is a terrible assumption, and a terrible premise, if you are concerned exactly about market liquidity.<\/p>\n

In fact, the idealization of full liquidity in every market is logically impossible in a world where market liquidity is provided by profit-seeking market makers. \u00a0In such an ideal world, market-making profit would be zero, so no market-maker would be willing to participate! The idealization thus makes most sense as a world where liquidity is provided for free by government. \u00a0It is thus quite inappropriate as a measure of how far current reality falls short of optimum.<\/p>\n

The report complains that regulators have addressed each market in isolation, without considering the overall impact of all the regulations added together on markets as a whole. \u00a0But the report itself commits exactly the same analytical error. \u00a0It thinks about market liquidity as something supplied by individual profit-seeking dealers, along the lines of the famous Ho and Stoll (1981) model (Ch. 2). \u00a0But it never asks about the properties of the system comprised of many such profit-seeking dealers competing with another. \u00a0They have a dealer model, but they have no money view.<\/p>\n

What they call bifurcation, I would simply call hierarchy or tiering, which is a natural and ubiquitous feature of all credit systems. \u00a0What they call fragmentation, I would simply call essential hybridity, different local balancing of money interest and public interest. \u00a0Maybe there is too much bifurcation and fragmentation, but maybe also there is too little; that’s what we need to discuss. \u00a0What we can say for sure is that zero bifurcation and zero fragmentation is impossible.<\/p>\n

The financial crisis made clear to everyone that the existing regulatory apparatus was inadequate for the emerging market-based credit system, as well as the larger financial globalization trend. \u00a0In the regulatory response that followed, we shifted the matched book dimension of market-making substantially to central clearing counterparties, and the speculative book dimension off of the balance sheets of banks (the Volcker Rule). \u00a0This shift \u00a0was not<\/strong> an inadvertent mistake, but rather a deliberate attempt to separate the liquidity risk of matched book (which arguably requires and merits public backstop) from the solvency risk of speculative book.<\/p>\n

That said, it is clear that we are feeling our way into the future, all of us. \u00a0The crisis revealed to everyone that abstraction from liquidity is abstraction from an essential feature of reality. \u00a0Markets have already responded by pricing liquidity more explicitly, appreciating that, like any scarce good, we need to make sure it is allocated wisely. \u00a0The question is not whether market liquidity is “invariably beneficial” or not, but rather whether the social benefit is greater than the social cost.<\/p>\n

 <\/p>\n","protected":false},"excerpt":{"rendered":"

The recently released PwC\u00a0“Global Financial Markets Liquidity Study”,\u00a0sounds a warning. \u00a0Financial regulation, while perhaps well-intentioned, has gone too far. \u00a0Banks may be safer but markets are more fragile. At the moment, this fragility is masked by the massive liquidity operations of world central banks. \u00a0But it will soon be revealed as, led by the Fed, […]<\/p>\n","protected":false},"author":15789,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":[],"categories":[1],"tags":[19,5,6,11],"_links":{"self":[{"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/posts\/104"}],"collection":[{"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/users\/15789"}],"replies":[{"embeddable":true,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/comments?post=104"}],"version-history":[{"count":1,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/posts\/104\/revisions"}],"predecessor-version":[{"id":105,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/posts\/104\/revisions\/105"}],"wp:attachment":[{"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/media?parent=104"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/categories?post=104"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/sites.bu.edu\/perry\/wp-json\/wp\/v2\/tags?post=104"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}