Liquidity, Bank Capital and Market Reform

A friend forwarded some thoughts on liquidity that are worth sharing here, as liquidity is central to the utility of assets as bank capital and to stabilising markets under stress. My friend's points are in bold, with my commentary below.

Central bankers and securities regulators lost sight of liquidity over the past decade or two in permitting reforms which compromised the health of the financial system. Thanks to the Greenspan and Bernanke puts, and to surplus recycling by Asian economies, many took liquidity - like oxygen - for granted. Like oxygen, you only realise how critical liquidity is when its absence becomes noticeable.

Now that bank regulators have rediscovered liquidity as an essential attribute of healthy banks and healthy markets, it is important to reinforce some key qualities.

Liquidity means you can generate cash from a physical asset or paper claim.

If you can't exchange the asset for a major currency to meet a sudden funding need, then the asset shouldn't be permitted as regulatory capital. Basel II and Basel III have generated hundreds of pages around credit scoring and asset type while ignoring the fact that most of what banks are attributing as capital cannot be turned into cash on demand.

Liquidity can be gained by sale or repo of an asset, preferably in a transparent market. Where no market exists or the market has become illiquid, then liquidity must be gained through a central bank.

Virtually all RMBS markets failed under stress in 2008 and 2009, with failures spreading to other asset classes as investors grew wary of dealer spreads and perceived shallow dealer commitment levels. As the scope of funding problems grew, illiquidity spread to sovereign debt for troubled countries such as Greece and Portugal. Few OTC asset markets have recovered sufficient liquidity for dealing in size.

When the public markets will not price an asset in size without a large spread, then the central banks become the market makers of last resort. Without central bank repo of illiquid RMBS and sovereign debt, virtually every major bank in the OECD would have failed.

Because they now have the role of market maker of last resort, central banks should become much more active in ensuring that any asset permitted to be classed as capital by a bank can be liquidated on demand in a public market. Rather than leaving market structure to the investment banks and their tame securities regulators, the central banks should be driving forward reforms to ensure that capital assets are issued in fungible series, in size, and traded in transparent exchange markets with committed market makers.

This will require a major policy reversal on exchange regulation. Securities regulators have been under pressure for several decades to liberalise OTC markets, permit fragmentation to off-exchange trading systems, and turn a blind eye to issuance of securities in small, idiosyncratic offerings that will never liquidly trade except back through the offering investment banks. The quality assurance and market conduct functions of exchanges have been eroded following demutualisation, and exchanges now are run for profit of their highly concentrated owners rather than in the public interest.

Markets are at the heart of successful civilisations. Markets require quality norms, information publication, and price transparency to operate effectively. Regulators and investors allowed credit ratings to substitute for exchange listing rules and reporting requirements during the liquidity boom. Ratings were gamed by the banks until they were meaningless. We should now be forcing assets back onto exchanges and force the exchanges to regulate quality and information norms in the public interest. If this requires re-mutualising the exchanges, or public ownership of exchanges, then that should be on the agenda. Letting the exchanges be run by the thugs who gamed the markets and the rating agencies isn't healthy.

Liquidity means that proceeds of sale will be paid as funds to your account in a currency you can use widely to meet obligations.

If you can only sell your asset into a market denominated in a currency which itself is not liquid and not legal tender for meeting your obligations, then you haven't got liquidity vested in the asset. A lot of investors in emerging markets are probably going to find that liquidity in those markets is a lot less than they might think, despite advances in exchange trading of emerging market assets, and the currencies might be less liquid too in a falling market. If they require funding in their home currency, they risk taking a big hit on sale and FX spreads when they realise the asset under stress.

Liquidity is measured by size, speed and spread - not by price levels.

Whatever the market price, a market isn't liquid if those holding assets in size cannot deal in size. A market is not liquid if those holding assets cannot sell at the time the sell decision is made, but must wait to identify or attract sufficient buyers. A market is not liquid if the spread between the bid and ask is so wide that buyers will be deterred from the market by the risk of never recovering the spread in appreciation or returns. The way that markets have levitated on minimal volumes in 2010 and 2011 is no indication that the markets are liquid. As we've seen in August, even mild selling can have a massive effect on prices in an illiquid market.

Short sales are an attribute of liquid markets. If a market can't be shorted, then the market will fail as prices fall.

Short sellers will come in to buy assets in a falling market to realise a profit. They provide liquidity when everyone else is too scared to deal.

Securities markets regulators and central bankers need to think through liquidity as an attribute of market structure in the public interest. Idiosyncratic, illiquid, ill-transparent deals and instruments which have dominated market growth for the past two decades are behind the weakness of bank capital and market recovery. The regulatory incentives should be toward standardisation of securities terms and offering documents, much larger issues of securities and series of bonds, and fungibility of asset types within a class. Exchange trading should be encouraged, fragmentation discouraged. Exchanges should provide rigorous listing rules, timely reporting of market relevant information, full price transparency and two-way quote obligations on market makers. If we got that right, then much of the misrepresentation, mispricing, inefficiency and fraud of the past would become impossible in future.

Insider Dealing or Insiders Scheming?

This should have gone up Friday, as I posted on RGE, but I've been up against a deadline and juggling multiple commitments before traveling this week.
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In the early 1990s, when Britain was in deep recession and banks and investment banks were under nasty financial pressures, the new Chairman of the Securities and Investments Board started a crusade against insider dealing. We all thought his obsession bizarre as London was then widely regarded as being the cleanest securities market in the world. Largely institutional, dominated by 25 or so market makers and fewer than 200 significant fund and pension managers, abnormal conduct was easily detected and brutally sanctioned. Since the average trade size in the cross-border market exceeded $270,000 and in UK stocks exceeded $80,000, it was very difficult for anyone to undertake a pattern of activity that went unscrutinised by their peers. NatWest (Blue Arrow) and Goldman Sachs (rigging the FTSE 100 options expiry) found to their cost at the time that their market counterparties and clients were very unforgiving of misconduct. A director of Goldman Sachs complained to me then that London was their least profitable operation globally.

Nonetheless, the SIB Chairman instigated a crusade, rallied the government, demanded tougher investigative powers and tougher penalties, and carried on as if London were a cesspool of corruption. We scratched our heads and wondered at it. He was and is a good man, even if we thought his efforts then over the top.

While insider dealing prosecutions never picked up much, he succeeded in imposing strict new transparency rules on the London Stock Exchange which quickly eroded its global dominance of equity markets. Transparency made market making impossible, as market makers need time to work a large order to quote a fine spread in institutional size from their own capital. Market making on the basis of quotes was gradually abandoned in favour of electronic order routing systems that transacted thousands of small orders dribbled out piecemeal into automated execution systems instead of finely priced large orders in size. From over 85 percent of global cross-border equity trading going through the London Stock Exchange at the peak in 1991, London’s market share collapsed as trading fragmented to smaller, more opaque markets elsewhere and to derivatives. Goldman Sachs profitability soared as the London Stock Exchange declined.

In this week’s announcement that the SEC will remove insider dealing enforcement from exchanges and concentrate it in two mega systems policed by NYSE and FINRA, I get an echo of this earlier era. I hope I am wrong, but it would not surprise me if once again police powers of regulatory authorities are used – with or without their conscious collaboration – to rig the market in favour of preferred models of interaction and preferred intermediaries.

Insider dealing is no more a threat to market integrity now than it was five years ago, ten years ago, or twenty years ago. If anything, insider dealing is more rampant in bull markets than bear markets.

On the other hand, it is true that insider dealing was much easier to detect when all dealing in securities was concentrated on exchanges rather than fragmented to multiple automated systems, dark pools and cross trading networks. It is also true that insider dealing was easier to detect before half the market volume fragmented to 8,000 unregulated hedge funds.

My concerns may have started with an echo of the UK in the 1990s, but they are aggravated by the pattern of state control and abuse of information observed over the past twenty years in the USA. George H.W. Bush created the “War on Drugs” in 1981 as vice-president of the United States to gain federal authority to monitor bank transactions and telecommunications and to seize property from anyone targeted by his special squads of DEA agents who were empowered to act outside normal due process and judicial review. Reagan then declared the "War on Terror" which Bush intensified as president later that decade, arrogating to himself and US intelligence agencies even broader powers beyond the review of democratic checks and balances. That morphed into the “War on Terror” under George W. Bush, who gained even more powers for the state to spy on its citizens and treat everyone as guilty until proven innocent, extrajudicially arrest and detain citizens and non-citizens alike, render them for torture globally, and otherwise abuse government powers.

It all started with sweeping up huge streams of data into unreviewable hands weilding huge power to seize and redistribute wealth. Forgive me then if I am sceptical when the SEC wants to protect investors by further concentrating both information and police powers.

The imposition of huge data sweeps in the name of “anti-money-laundering” in the banking sector and combating “insider dealing” in securities markets reeks of the same tactics and objectives as telecoms or internet search engine sweeps to the NSA.

Ronald Reagan once quipped that the biggest lie was, "I'm from the government and I'm here to help you." Given the pattern of abuse in his administration, and the subsequent treatment of US workers and taxpayers, he may have been more truthful than he knew. So what should we think when we hear, "I'm from the SEC and I'm here to protect you"?

Needless to say, the more data collection and police powers are concentrated in a single authority, the more difficult it becomes for anyone to contest an investigation or enforcement action by that authority. Without objective protections, alternative sources of confirmatory data, guarantees of judicial review and due process, it becomes impossible to challenge the arbitrary use of authority or the deliberate misuse of authority.

Think of just one scenario: a target firm becomes the subject of a very public investigation and charges. Its share price collapses, and investors flee. Enter a well-funded vulture fund who takes out the very best assets and a very well-connected competitor who sweeps up the choicest clients.

I hope you are not about to see in the United States a darker variation on the much milder reshaping of the markets I observed in Britain in the early 1990s. It is perhaps as well to be aware, however, that the new insider dealing powers in a single authority can be applied selectively to erode markets and undermine market participants who threaten those who wield the real power.

I would like to see more substantiation of the rationale for centralising data collection and enforcement, and more controls on the abuse of information and powers, before trusting that the regulators are acting in the interests of investors and of the greater economy as a whole.

Why not have an open database of anonymised transaction data that is reviewable and searchable by all market intermediaries and investors? That would allow anyone to investigage suspect patterns of transactions for reporting. But then that might catch the wrong people in the net and expose too many to scrutiny.

It has taken me many years to understand my discomfort with reforms in the early 1990s recession. I am worried that the proper function of markets in the intermediation of capital investment so critical to the prosperity of any economy may be further distorted and eroded. If competition is so good for capitalism, then surely markets should have to compete to demonstrate their ability to uphold efficient price discovery and market integrity. Regulators too should have to compete if only to promote vigilence in each other by maintaining reputation risk.

Harmonisation of market structure and regulation may be harmful if it tends toward sub-optimal choices. Without competition and independent data collection, we may never be able to prove that the choices our regulators make for us are not in our best interest.