6

Grit is Good

PARIS – The United States is widely recognized as possessing the deepest, most liquid, and most efficient capital markets in the world. America’s financial system supports efficient capital allocation, economic development, and job creation.

These and similar phrases have been common currency among American legislators, regulators, and financial firms for decades. Even in the wake of the financial crisis that erupted in 2008, they trip off the word processors of a hundred submissions challenging the so-called Volcker rule (which would bar banks from making proprietary investments). The casual reader nods and moves along.

But there are signs that these assumptions are now being challenged. Prior to the crisis, regulatory authorities focused mainly on removing barriers to trading, and generally favored measures that made markets more complete by fostering faster, cheaper trading of a wider variety of financial claims. That is no longer the case. On the contrary, nowadays many are questioning the assumption that greater market efficiency is always and everywhere a public good.

Might such ease and efficiency not also fuel market instability, and serve the interests of intermediaries rather than their clients? Phrases like “sand in the machine” and “grit in the oyster,” which were pejorative in the prelapsarian days of 2006, are now used to support regulatory or fiscal changes that may slow down trading and reduce its volume.

For example, the proposed Financial Transactions Tax in the European Union implies a wide-ranging impost generating more than €50 billion a year to shore up the EU’s own finances and save the euro. The fact that 60-70% of the receipts would come from London is an added attraction for its continental advocates. Opponents argue, in pre-crisis language, that the FTT would reduce market efficiency and displace trading to other locations. “So what?” supporters reply: maybe much of the trading is “socially useless,” and we would be better off without it.

The Volcker rule (named for former Federal Reserve Chairman Paul Volcker) provoked similar arguments. Critics have complained that it would reduce liquidity in important markets, such as those for non-US sovereign debt. Defending his creation, Volcker harks back to a simpler time for the financial system, and refers to “overly liquid, speculation-prone securities markets.” His message is clear: he is not concerned about lower trading volumes.

There is more grit on the horizon. In a penetrating analysis of the “Flash Crash” of May 6, 2010, when the Dow lost $1 trillion of market value in 30 minutes, Andy Haldane of the Bank of England argues that while rising equity-market capitalization might well be associated with financial development and economic growth, there is no such relationship between market turnover and growth.

Turnover in US financial markets rose four-fold in the decade before the crisis. Did the real economy benefit? Haldane cites a striking statistic: in 1945, the average investor held the average US share for four years. By 2000, the average holding period had fallen to eight months; by 2008, it was two months.

There appears to be a link between this precipitous drop in the average duration of stock holdings and the phenomenon of the so-called “ownerless corporation,” whereby shareholders have little incentive to impose discipline on management. That absence of accountability, in turn, has contributed to the vertiginous rise in senior executives’ compensation and, in financial firms, to a shift away from shareholder returns and towards large payouts to insiders.

But Haldane’s main concern is with the stability of markets, particularly the threats posed by high-frequency trading (HFT). He points out that HFT already accounts for half of total turnover in some debt and foreign-exchange markets, and that it is dominant in US equity markets, accounting for more than one-third of daily trading, up from less than one-fifth in 2005.

The rapid, dramatic shifts brought about by HFT are likely to continue. It is only a decade since trading speeds fell below one second; they are now as fast as the blink of an eye. Technological change promises even faster trading speeds in the near future.

Indeed, HFT firms talk of a “race to zero,” the point at which trading takes place at close to the speed of light. Should we welcome this trend? Will light-speed trading deliver us to free-market Nirvana?

The evidence is mixed. It would seem that bid-offer spreads are falling, which we might regard as positive. But volatility has risen, as has cross-market contagion. Instability in one market carries over into others.

As for liquidity, while on the surface it looks deeper, the joint report on the Flash Crash prepared by the US Securities and Exchange Commission and the US Commodity Futures Trading Commission shows that HFT traders scaled back liquidity sharply, thereby exacerbating the problem. The liquidity that they apparently offer proved unreliable under stress – that is, when it is most needed.

There are lessons here for regulators. First, their monitoring of markets requires a quantum leap in sophistication and speed. There is a case, too, for looking again at the operation of circuit-breakers (which helped the Chicago markets in the crash), and for increasing the obligations on market makers.

Such steps must be carefully calibrated, as greater obligations, for example, could push market makers out of the market. But Haldane’s conclusion is that, overall, markets are less stable as a result of the sharp rise in turnover, and that “grit in the wheels, like grit on the roads, could help forestall the next crash.”

So the traditional defense of US and, indeed, European capital markets is not as axiomatic as it once seemed. Market participants need to engage more effectively with the new agenda, and not assume that claims of greater “market efficiency” will win the day. Without more sophisticated arguments, they might well find themselves submerged under a pile of regulatory sandbags.