This will be a brief but hopefully helpful column. For some time, I have been explaining that the new Fed operating framework for monetary policy, in which the FOMC essentially steers interest rates higher by fiat rather than in the traditional method (by managing the supply of funds and therefore the resulting pressure on reserves), is a really bad idea. But in responding to a reader’s post I inadvertently hit on an explanation that may be clearer for some people than my analogy of a doctor manipulating his thermometer to give the right reading from the patient.
Right now, there is a tremendous surplus of reserves above what banks are required to hold or desire to hold. With free markets, this would result in a Fed funds interest rate of zero, or even lower under some circumstances, with a substantial remaining surplus. In this case, the Fed funds effective rate has tended to be in the 10-20bps range since the Fed started paying interest on excess reserves (IOER).
So what happens when there is a floor price established above the market-clearing price? Economics 101 tells us that this results in surplus, with less exchange and higher prices than at equilibrium. Consider a farm-price support program where the government establishes a minimum price for cheese (as it has, actually, in the past). If that price is below the natural market-clearing price, then the floor has no effect. But if the price is above the natural market-clearing price, as in the chart below where the minimum cheese price is set at a, then in the market we will see a quantity of cheese traded equal to b, at a price of a.
But what also happens is that producers respond to the higher price by producing more cheese, which is why the supply curve has the shape it does. In order to keep this excess cheese from pushing market prices lower, the government ends up buying c-b cheese at some expense that ends up being a transfer from government to farmers. It can amount to a lot of cheese. This is the legacy of farm price supports: vast warehouses of products that the government owns but cannot distribute, because to distribute them would push prices lower. So the government ends up distributing them to people who wouldn’t otherwise buy cheese, at a zero price. And eventually, we get the Wikipedia entry “government cheese.” https://en.wikipedia.org/wiki/Government_cheese
Now, this is precisely what has happened with the artificial price support for overnight interest rates. Whatever the clearing interest rate is with the current level of reserves, it is lower than the 0.25% IOER (and we know this, among other ways, because there are excess reserves. If the price floating to the actual clearing price, then there would be no excess reserves, although the mechanism for this result is admittedly more confusing than it is for cheese). So the Federal Reserve is forced to “buy up the surplus reserves” by paying interest on these reserves; this amounts to a transfer from the government to banks, rather than to farmers in the cheese example.
You should realize too that setting the floor rate higher than the market-clearing rate artificially reduces the volume of trade in reserves. The chart below, which comes from this article on the New York Fed’s blog, illustrates this nicely.
Creating such a floor also causes the supply of excess reserves themselves to increase beyond what it would otherwise be. This confusing result derives because while the Fed supplies the total reserves number to the market, banks can choose to create more “excess” reserves by doing less lending, or can create fewer excess reserves by doing more lending. Of course, banks aren’t deciding to create excess reserves per se; they are deciding whether it is more advantageous to make a loan or to earn risk-free money on the excess reserves. A higher floor rate implies less lending, all else equal – and, as I have said in the past, this means the Fed could cause a huge increase in bank lending by setting IOER at a penalty rate. This would create the conditions necessary for these lines to cross in negative nominal interest rate territory, with much higher volumes of credit and much lower levels of excess reserves being the result.
In this environment, and as recognized by the Sack-Gagnon framework that is now the presumed operating framework for Fed policy, raising IOER is the only way to change the overnight interest rates unless the Desk undertakes to shift the entire supply curve heavily to the left, by draining trillions in reserves. But raising IOER, just like raising the floor price of cheese, will create more imbalances: bigger excess reserves, less lending, and a bigger transfer from government to banks.
(Note: this is subtly different from what I have said before, which is that raising IOER will have no effect on the growth rate of the transactional money supply. Depending on the shape of the supply curve, it will reduce lending which in turn may reduce the growth rate of the monetary aggregates that we care about, such as M2. My suspicion is that the supply curve is in fact pretty steep, meaning that banks are relatively insensitive to small changes in rates, and thus loans and hence the monetary aggregates won’t see much change in the rate of growth – or, more likely, any change will be the result of other effects beyond this one such as the effect of general economic prospects on the quality of credits and the demand for loans).
Price supports, as any economist can tell you, are an inefficient way to subsidize an industry. And in fact, I don’t think the Fed is really interested in subsidizing banks at this stage in the cycle: they seem to be doing just fine. But they are taking on all of these imbalances, creating all of this government cheese, because they believe the effects I talk about parenthetically above are quite large, rather than vanishingly small as I believe. And the ancillary effect, by raising interest rates, is to spur money velocity – an unmitigated negative in this environment, as it will push inflation higher.
Now, all of this discussion may be moot since the current betting is that the Fed won’t raise interest rates any time soon. But it is good to understand this mechanism as clearly as we can, so that we can prepare ourselves for those effects when they occur.
 It is really hard to say how low interest rates would go, and/or how much surplus would remain, because we have no idea at all what the supply and demand curves for funds look like at sub-zero rates. Most likely there is a discontinuity at a zero rate, but how much of one and the elasticities of supply and demand below zero are likely to be “weird.”
 In fact, in high school I won an economics prize for my paper “That’s a Lotta Cheese.” No joke.
I am generally reluctant to call anything a “game changer,” because in a complex global economy with intricately interdependent markets it takes something truly special to change everything. However, I am tempted to attach that appellation to the ECB’s historic action this morning. It probably does not “change the game” per se, but it is very significant.
Feeble money growth in the Eurozone has been a big concern of mine for a while (and I mentioned it as recently as Monday). In our Quarterly Inflation Outlook back in February, we wrote:
“The new best candidate for having a lost decade, now, becomes Europe, as it sports the lowest M2 growth among major economic blocs… It frankly is shocking to us that money supply growth has been so weak and the central bank so lethargic towards this fact even with Draghi at the controls. It was generally thought that Draghi’s election posed a great risk to price stability in Europe… but in the other direction from what the Eurozone is now confronting. There have been murmurings about the possibility of the ECB instituting negative deposit rates and other aggressive stimulations of the money supply, but in the meantime money growth is slipping to well below where it needs to be to stabilize prices. Europe, in our view, is the biggest counterweight to global inflationary dynamics, which is good for the world but bad for Europe.”
All of that changed, in one fell swoop, today. The ECB’s actions were unprecedented, and largely unexpected. First, and somewhat expected, was the body’s decision to implement a negative deposit rate for bank reserves held at the ECB. This is akin to the Fed incorporating a negative rate for Interest on Excess Reserves (IOER). What it does is to actually penalize banks for holding excess reserves.
There are two ways for a bank to shed excess reserves. The first way is to sell the reserves to another bank in the interbank market. This doesn’t change anything about the aggregate amount of excess reserves; it just moves those reserves around. In the process, it will push market interest rates negative (since a bank should be willing to take any interest rate that is less negative than what the ECB is charging) and probably increase retail banking fees at the margin (since there is otherwise no way to charge depositors a negative rate). This will weaken banks, but doesn’t increase money growth. The second way a bank can shed excess reserves is to lend money, which increases the reserves it is required to hold and therefore changes the reserves from excess to required. A bank is incentivized to make marginally riskier loans (which lowers its margins due to increased credit losses) because there is a small advantage to using up “expensive” reserves. This also will weaken banks. But, more importantly, it will stimulate money growth and that is what the ECB is aiming for.
If that was all the ECB had done, though, it would not be terribly significant. The utilization of the ECB’s deposit facility is only about €29bln at this writing, which is already near the lowest level since the crisis began (see chart, source Bloomberg).
But the ECB did not stop there. At the press conference after the formal announcement, Draghi unveiled a package of €400bln in “targeted” LTRO, which means that if banks lend the money they acquire through the LTRO then the term of the loan is four years; otherwise it must be paid back in two years. Even more important, the central bank suspended the sterilization of LTRO. “Sterilization” is when the bank soaks up the reserves created by the LTRO. As long as the ECB was sterilizing its quantitative easing, it could not have any impact. It is similar, but more extreme, to what the Fed did in instituting IOER to restrain banks from actually using the reserves created by QE. It never made much sense, but in the ECB’s case there was evidently some concern that doing QE without sterilization was not permitted under the institution’s charter.
Apparently, those concerns have been resolved. But QE without sterilization is meaningful. The ECB is thus not only doing quantitative easing, but is actively taking steps to make sure that the liquidity being added to the system is flushed, rather than leaked, into the transactional money supply.
If the ECB actually follows through on these pledges, then we can expect a rapid turn-around in the region’s money growth, and before long a turn higher in the region’s inflation readings. And, perhaps, not merely for the region: the chart below (source: Bloomberg, Enduring Investments) shows the correlation between core CPI in the US and the average increase in US and Eurozone M2. Currently US M2 is growing at better than 7% over the last year, while Eurozone M2 is 1.9%. Increasing the pace of M2 growth in Europe might well help push US inflation higher – not that it needed any help, as it is already swinging higher.
The renewed determination of the ECB to push prices higher should as a result be good not only for European inflation swaps (10-year inflation swaps were up 2-3bps today, but have a long way to go before they are back to normal levels – see chart, source Bloomberg), but also for US inflation swaps (which were up 1-2bps today).
Finally, if it is true that central bank generosity is what has been underpinning global asset markets, an aggressive ECB might give a bit more life to global equities. Perhaps one more leg. But then again, perhaps not – and when the piper’s tune is over, it could be brutal. It is currently quite dangerous to be dancing to that piper. For my money, I’d rather be long breakevens.
 This is interesting for lots of reasons, but one of them is that the ECB will measure (if I understand correctly) the net lending of the institution, so if that contracts then the loan will be called. But there are lots of reasons for an institution to decrease lending. Some of them, such as a generally weak economic environment or a weak balance sheet of the bank, would be exacerbated by an unwelcome “call” of the loan by the ECB. In the former case it would exacerbate a weak economic situation; in the latter it could accelerate a bank collapse. I may not understand the conditions for the call, but if my understanding is correct then this is a curious wrinkle.
News flash! High-frequency trading (HFT) is happening!
The “60 Minutes” piece on HFT that aired this weekend ensured that now, finally, everyone has heard of HFT. Even “60 Minutes” has now heard of it, four years after the Flash Crash and more than a decade after it began. Apparently the FBI is now suddenly concerned over this “latest blemish.”
Again, this is hardly new. Here is the record of Google search activity of the term “high frequency trading.”
So why is it that, for years, most of the world knew about HFT and yet no one did anything about it?? According to author Michael Lewis, the stock market is rigged! There should be an uproar (at least, there should be if you are selling a book). Why has there been no uproar previously?
To put it simply: this is a crime where it isn’t clear anyone is being hurt, Lewis’s panicky declaration notwithstanding. Except, that is, other high-frequency traders, who have fought over the tiny fractions of a penny so hard that the incidence of HFT is actually in decline. Let’s be clear about what HFT is, because there seems to be some misunderstanding (one commentator I saw summarized it as “the big banks buy the stock and then the retail investor buys it 5%-10% higher.” This would be a problem, if that’s what was happening. But it isn’t. The high frequency traders are playing for fractions of a penny. And the person they are stepping in front of may be your buy order, or it may be the offer you just bought from – if you ever see fills like $20.5999 when the offer was $20.60, then you were injured to the tune of minus 1/100 of a cent per share. The whole notion of HFT is to be in and out of a position in milliseconds, which basically limits expected profits to a fraction of the bid/offer. And when there are lots of high frequency traders crossing signals? Then the bid/offer narrows. That’s not a loss to you – it’s a gain.
High frequency traders aren’t just buying and pushing markets up. They are buying and selling nearly-instantly, scalping fractions of pennies. From all that we know, they have no net effect on prices. Indeed, from all that we know, both the beneficial aspects and the negative aspects remain unproven (see “What Do We Know About High Frequency Trading?” from Charles Jones of the Columbia Business School.
So, if you’re being ripped off, it’s far more likely that you’re being ripped off by commissions than that you’re being ripped off by the robots.
But let’s suppose that the robots do push prices up 5% higher than they would otherwise be. Either that’s the right price to pay…in which case they made the market more efficient by pushing it nearer to fair value…or it’s the wrong price to pay, in which case the only way they win is by selling it to someone who pays too much. If that’s you, then the robots aren’t the problem – you are. Stop giving them a greater fool to sell to, and they will lose money.
Now, this is all good advertising for another concept, which needs to be stated often to individual investors but probably could be said in a nicer way than “you’re getting ripped off by robots”: yes, the market is full of very, very smart people. And yet, on average returns cannot be above-average! This means that if you don’t know everything there is to know about TSLA and you buy it anyway, then you can be sure you will still own it, or be still buying it, when the smart guys decide it is time to sell it to you. They don’t have to have inside information to beat you – they just have to know more than you about the company, about valuations, about how it should be valued, and so on. This is why I very rarely buy individual equities. I am an expert in some things, but I don’t know everything there is to know about TSLA. I am the sucker at that table.
Long-time readers will know that I am no apologist for Wall Street. I spent plenty of time on that side of the phone, and I have seen the warts even though I also know that there are lots of good, honest people in the business. The biggest problems with Wall Street are (a) those good, honest people aren’t always fully competent, (b) the big banks are too big, so that when you get weak competence and very weak oversight combined with occasional dishonesty, there can be serious damage done, (c) there is not a strong enough culture at many firms of “client first;” although that doesn’t mean the culture is “me first,” it means the client’s needs sometimes are forgotten, and finally (d) the Street is not particularly creative when it comes to new product development.
And I don’t really like the algo traders and the movement of the business to have more robots in charge. But look, this trend (not necessarily HFT but automated trading) is what you get when you start regulating the heck out of the humans. Which do you want? Kill the robots, and you need more of those dastardly humans. Remove the humans, and those lightning-quick robots might trade in front of you. Choose. In both cases, you will be victimized less if you (a) trade large and liquid indices, not individual equities, and (b) trade infrequently.
The far bigger problem in my mind is the opacity, still, of bond trading and the very large bid/offer spreads that retail investors pay to buy or sell ordinary Treasury bonds that trade in large size – often billions – on tiny fractions of 1% of price. Think of it: in equities, with or without HFT you will get a better price for a 100-lot than for a 1,000,000-lot. But in bonds, you will get a vastly better price for a billion than for a thousand. Now that is where a retail investor should get angry.
Here is a post from Sober Look that has some really good charts on the changing asset mix at US banks. I was a little surprised that they didn’t point out the obvious connection in the charts, although they do make some key points in a previous post.
To summarize: the charts show that the loan-to-deposit ratio in the banking system recently hit a 35-year low, and that the proportion of cash on the balance sheet of banks has gone from maybe 5% to around 20% (eyeballing it) in the last ten years.
Obviously, these two facts are not unconnected, since loans and cash are both assets to banks. The reason for the shift from loans to cash is very simple: QE. Banks don’t want to hold as much cash (reserves) as they are carrying, but the alternative is to lend it to people in sub-optimal loans – that is, where the interest rate charged does not compensate for the risk that the loan will not be paid back, so that the lending has a negative NPV. Moreover, the cash itself has a positive return because the Fed is paying interest on excess reserves, so that the lending has a higher hurdle to achieve than it would if this was just “normal” cash or reserves.
Understanding this dynamic is really important. So here’s how this works: if interest rates rise, but reserves have the same yield, then lending becomes more profitable and loans will increase – that is, the money multiplier will rise, with less money in the vault and more money in transactional accounts. If, on the other hand, the Fed raises the interest on excess reserves while lending rates stay unchanged, then even fewer loans will be made and banks will hold more cash relative to loans. This is one mechanism by which higher interest rates initially encourage higher inflation.
(And yes, while the total amount of reserves in the system is fixed, the total amount of loans is not, so while the Fed controls the former they do not control the latter except indirectly).
So, consider the “exit” strategy. As interest rates rise, the multiplier will increase unless the Fed hikes interest on excess reserves. But since interest rates move more flexibly, more rapidly, and often further than do policy rates, this probably means the multiplier will be determined mostly by the market (I wonder if the Fed declared the IOER to be “10-year yields minus 250bps” if that would change things?). The gap is the thing. And, if Yellen actually cuts the IOER to zero, as she has intimated is possible, then the multiplier would rise…and we don’t know by how much.
On the flip side, if the Fed tapers QE to zero, and lending rates fall, then the multiplier would tend to fall further because that gap narrows. In that case, you really could get a disinflationary scenario…though I am skeptical that long rates can fall very much when public debt is so high and the Fed is withdrawing its support for the bond market. Still, a crisis could do it. To be clear: you’d need the Fed to stop adding reserves, to neglect the IOER – or increase it – and long rates to decline substantially (at least 100bps, say). So if you are a deflationist, there are your signposts. I don’t anticipate that any of that happening, except that I imagine they will screw up the IOER strategy and they could screw that up in either direction.
And by the way, I don’t think any of that would affect inflation much in 2014, since higher housing prices are already going to be pressing core inflation higher. But it could affect 2015.
However, I digress from the other point I wanted to make that was suggested by the Sober Look article, and that is this: it continues to amaze me how well bank stocks are trading. I’ve been saying this for years – which helps to illustrate that I am a strategic investor, not a twitchy tactical guy. Return on equity equals gross margin (profit/revenue), times asset turnover (revenue/assets), times leverage (assets/equity), and for banks all three of these components are under pressure. Gross margin is under pressure from the movement of more products to electronic trading and from increasing legal bills at banks (the FX trading scandal is the latest threat of multibillion-dollar fines, adding to the LIBOR scandal and probes of the gold and silver price fixing system as sources of legal headaches for banks). Banks have been forced via the crisis to shed leverage, as a chart I recently ran illustrated. And low interest rates combined with large amounts of cash compared to loans on the balance sheet pressures the asset turnover statistic. So it isn’t surprising that bank ROEs are low (see chart of the NASDAQ bank index ROEs, source Bloomberg). What is surprising is that they even got this high, and market pricing seems to anticipate that they’ll keep rising. Bank stocks are actually outperforming the S&P since late 2011, and their P/E ratios are essentially where they have always been, excluding the spike when earnings collapsed in the crisis, causing P/Es to skyrocket (see chart, source Bloomberg).
Note: The following blog post originally appeared on March 13, 2012 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
I had not planned to write tonight, but there was too much that happened today, and too much that is likely to be misunderstood and misinterpreted. Not, necessarily, that what follows will help that situation, but I felt a need to add my two cents (which, don’t forget, is two cents more than you paid for it, so you’re two cents ahead no matter what).
And this takes us to the final, and most interesting, event of the day. It began when JP Morgan trumpeted a nickel increase in its dividend and a $15bln stock buyback. My first reaction was that this is not a phenomenon you tend to see in bear markets or early in bull markets, but rather in mature bull markets. Firms have a marked tendency to buy stock back when it’s expensive, not when it’s cheap, and an even more marked tendency to announce a buyback when they want a stock price supported. An announcement of a buyback program is not a promise to buy, and often no stock is actually bought. It is only an announcement of an intention to buy, which the firm need not honor. And this is a bank. Anyone with even a passing knowledge of Basel III knows that banks are going to be raising Tier 1 capital – especially in Europe, but in the U.S. as well – for a while. There is no way that banks, whether or not they feel overcapitalized by 2000s standards or not, are actually going to be buying back large chunks of stock. So my second thought was “wow, are they actually going to scare up the stock so that they can sell more? That can’t be legal.”
Moments later, we found out what the real point was. It seems the Fed had completed the stress tests and informed all of the banks a couple of days ago (it’s unclear when), and were going to make a public announcement on Thursday.
Sidebar: This is why people think that Wall Street is run by a bunch of crooks. The moment that banks had this information, they were in possession of material nonpublic information that should have been immediately released if the banks were going to prepare any offering in their own securities. Whether the Fed says they can or can’t, the information must be released. And here is one positive checkmark for JPM: they announced that the Fed had approved their buyback and dividend plans in the context of passing the stress test. But thanks a lot, Fed, for putting banks in the awkward position of having to choose between ticking off the Fed, or ticking off the SEC. And great job, bank managements, for mostly choosing to keep a secret that makes you look like a member of an elite club/secret cabal, rather than choosing to release the information. Good job, JPM. (But I’m not done with you yet).
So, the Fed decided that they needed to immediately release the stress tests results, early. Well, not immediately; they decided to wait until 4:30ET, after the markets closed to retail investors, because golly it would be too much to ask to let people get the information when the markets were open. Sidebar: this is why people think the Fed is run by a bunch of crooks who are in bed with the Wall Street crooks. Who is running the PR at the Fed?
Bank of America bravely followed JP Morgan through the breach to announce that they, too, had passed the stress tests. US Bank announced a share buyback, dividend hike, and a passing stress test grade. (Quick quiz, with the answer to be given later: are the banks announcing share buybacks likely to be the strong banks or the weak banks with respect to the stress test? Write down your answer and we’ll come back to it.) Volume on the exchange spiked, with better than 50% of the day’s volume coming in the last hour of trading, and almost 30% in the last 7 minutes before the bell.
The stress test results were released, and four financials failed: Ally Financial, SunTrust, MetLife, and Citigroup. Well, good luck raising capital now, Citi. (Important Disclosure: I am expressing no opinion on any of these individual equities or any of the other securities of these companies. I neither own, nor intend to buy, nor sell, any of their securities in the near future. My negative opinion on banks generally is well-known, but I do not have any position, positive or negative, on the banking sector, nor do I plan to make such a sector bet in the near future).
Now, initially the press coverage listed three of the four firms that failed, but not MetLife, so I was forced to go skimming through the “CCAR” report to find the fourth one. If I hadn’t done that, I almost certainly would not have noticed Figure 7, which is reproduced below for your easy reference.
You can see the four banks which failed are the shortest bars on this chart, so you can easily pick out Ally, Sun Trust, Citi, and with a straightedge you can conclude that MetLife is the fourth. But then it’s a really close race for fifth-worst with KeyCorp, US Bank, Morgan Stanley, and… JP Morgan. It must be great to be JP Morgan. When you wonder why they drew the line where they did, you might imagine the counterfactual situation where JP Morgan came out on the other side of the line. JP Morgan, which was the Fed before there was a Fed, and will probably be the Fed after the Fed is gone. JP Morgan, which the Fed called on multiple times during the crisis to save the world (for example, by serving as a lending conduit to entities which the Fed could not directly lend to). I wonder what the odds are that JP Morgan would be allowed to fail? I’m going to speculate: zero. And that’s why the line is where it is.
Now, it is interesting to see which banks scored very highly. They’re banks that don’t have exposure to as many of the blow-up areas that were tested by the Fed (which is not to say they aren’t exposed to blow-ups: just that they’re not the ones that the Fed tested).
By the way, don’t let anyone tell you “well, this was a really severe test, and so these banks are actually in really good shape.” Yes, this test is much more stringent than the cotton-candy version the European regulators put their banks through last year, but it only measures expected reactions to broad macroeconomic events, and not the interaction of the entire system under such a stressful scenario. That reaction is non-linear, and it is very difficult to model. Moreover, we can’t model the unknown: a rogue trader, a $65billion Ponzi scheme, a tsunami and nuclear meltdown in Japan, a terrorist attack in New York. As Roseanne Roseannadanna used to say, “It’s always something.”
When all is said and done, are we better off that the Fed did these stress tests? I suppose the answer is yes, if only because it means the regulators actually took some interest in looking at these businesses and their risks. But if it creates a false sense of comfort, or reverses the trend towards greater capital cushions, then probably not. Time will tell.
I am about ranted out for today, and there are no important economic releases tomorrow. It will be interesting to see how the spin machines work on Citigroup and JP Morgan, which are after all separated by only a thin line on Figure 7, but by a huge gulf in reputation.
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I wrote recently about money velocity and reminded readers that theory says higher interest rates tend to increase money velocity because it decreases the demand for real cash balances. This was around the discussion of whether the enormous demand for Verizon bonds could be anecdotal evidence that velocity is increasing.
Yesterday the blog Sober Look – which is one of my favorites because it gives intelligent looks at many different markets – ran an article entitled “Could rising rates fuel credit growth in the US?” in which they in turn cite Deutsche Bank research. It’s a very quick article and worth a read, because it sheds some light on one of the mechanisms by which credit growth may increase with higher rates. Ordinarily, higher rates inhibit money growth at the same time that they increase velocity, partly because the yield curve flattens. But in this case, higher rates may increase both credit growth and money velocity – at least when rates initially rise – since the market is moving ahead of the Fed and steepening the yield curve in a selloff.
It’s just another puzzle piece to rotate in your mind, to try and see how it all fits together!
When I remark, from time to time, that I think the Fed has made a mistake in increasing transparency of its deliberations and actions, people occasionally look at me as if I had come out opposed to motherhood or apple pie. But my point is that transparency is good if it permanently decreases risk…but it doesn’t.
What matters is how market actors respond to increased transparency. It is much like the old debate about whether football players ought to wear helmets. It is clear that helmets decrease the likelihood of brain damage in any given collision, compared to the un-helmeted rider in an identical collision. But it is also clear that as helmets have gotten better and better, football players have played faster and faster, with more abandon, and lead with their heads a lot more than they did when all they had was a leather cap. The net effect is indeterminate.
In markets, increased transparency from a central bank or regulator leads to increased leverage in a very direct way. The central bank’s dial is for transparency, but the investor’s dial is for risk appetite and when the central bank turns its dial it does not change the investor’s risk preferences. The result is that increasing transparency, which decreases the risk at any given leverage and at any particular moment, leads to higher levels of leverage, which lowers the tolerance for error. And, as we have seen, central banks and regulators are quite prone to error.
In an interesting way, this is tied into the volume question. The chart below (source: Bloomberg) shows rolling 250-trading-day volume for the NYSE in billions of shares. As has been well-documented, market volumes have been steadily declining for years.
As we have mentioned here before, there are lots of excuses for lower market volumes on the major exchanges, and probably many of those excuses are part of the answer. But we can no longer simply attribute this to the movement of volumes to “dark pools.” There is simply less going on in the markets, whether in rates or in equities. Ask the dealers. Dodd-Frank and the Volcker Rule are simply decimating volumes. And this is not just bad for dealers, it is bad for everyone.
When a trade happens, there is information revealed. Indeed, in some markets a meaningful proportion of the volume transacted is between dealers who are testing the market to get more information. More trades means that there are more quanta of information. More quanta of information produces more confidence in prices. More confidence in prices means more support for the current prices, and more de facto liquidity.
Think of it this way. If a bond has never traded, and two counterparties come together to trade some at a price of 103, what is your estimate of the true market for another trade? Is it one tick around 103? If so, then you are displaying almost outrageous overconfidence – one data point between two counterparties, about whose motivations you know precisely nothing, tells you almost zero about what the true market (by which I mean, the prices at which you could buy, for an offer, or sell, for a bid, a typical-sized transaction) is, and even less about what the support market (by which I mean the prices at which you could transact in substantially larger sizes) is. And so bid/offer spreads, whether quoted on-screen or over-the-counter from a dealer in the security, must be wider since the market-maker just doesn’t know as much as he would if volumes were higher – and, more to the point, the market must be wider because the client who initiates the trade is likely to know more than the market-maker does about the right price. This is because the market-maker must make a market whether or not he knows the fair price, but the buyer or seller doesn’t have to trade unless he/she believes the fair price is outside of the quoted range. Of course, that’s where the information comes from: if the offer is lifted, it means someone is saying “I think the fair price is higher than your offer,” and that is information.
I mention this today for several reasons. First, because it has been a while since I showed the NYSE volumes chart in a while. Second, because there was an article on Bloomberg today entitled “Professor Who Helped Pop Junk Bubble Says Trace Slows Trade” which ties transparency to diminished volumes. To the extent that Trace produces true transparency and reduces the need for “testing” trades, it is a good thing…but then we should see tighter spreads for size, and while the study is suggestive it isn’t conclusive on this point. More interestingly, the professor in question also made the point that “less trading may hurt investors if, instead of reducing ‘noise’ from the market, the reduction slows how quickly new information alters prices.” And this point is also key:
”…if the decrease in trading activity is the result of dealers’ unwillingness to hold inventory, transparency will have caused a reduction in the range of investing opportunities. That is, even if a decline in price dispersion reflects a decrease in transaction costs, the concomitant decrease in trading activity could reflect an increased cost of transacting due to the inability to complete trades.”
So transparency, it seems, is not an unalloyed positive like apple pie. But lower trading volumes, which are partly the result of transparency (and partly the result of poorly-conceived rules like Dodd-Frank, the Volcker Rule, and Basel III), are very probably bad for everyone. This doesn’t just affect hedge funds. Markets which are deep and liquid are much less prone to sudden price breaks. With the US equity market still floating near the highs despite rapid increases in nominal and real interest rates and worst-ever outflows from ETFs last month, this is a point that may be more than academic at the moment.
 However, no one disputes that the faster game is a lot more fun to watch. What I suspect has happened is that the introduction of hard-sided helmets probably increased injuries until players essentially reached maximum speed/recklessness, after which point the further improvements in helmet design probably started to make the game safer again. But it is really hard to prove that.