Tuesday, December 29, 2015

Why liquidity is no guarantee for 'value' discovery?

John Kay has a delightful piece, where he seeks to upend the conventional wisdom on liquidity, that assets need to be tradeable every milli-second so as to generate volumes. Supporters of this view blame the increased regulation in the aftermath of the global financial crisis for the reduction in liquidity. But Kay argues that neither the savers (who lend) nor businesses (who borrow) need this kind of liquidity,
There is not much trade or liquidity in these (corporate bond) markets because there is not much need for trade or liquidity in these securities. The practitioners were 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.
And about what is needed, he writes,
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.
It was reported by the US Commodity Futures Trading Commission that this year itself, till September, there had been 35 "flash events" in the market for West Texas Intermediate crude futures. This is more reminder (like this, this, and this) to those who celebrate the power of more liquidity exemplified in trends like high-frequency trading etc. Amen!

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