What I really think about Finance

Robert Waldmann

While blogging here at Angry Bear, I have been almost as blunt and direct as I am ignorant, but I would like to be much more frank in this post. The question, roughly, is which innovative financial instruments and trading strategies are socially useful. This is important, because people argue against draconian regulation on the grounds that it will block financial innovation and/or interfere with the trading strategies of legitimate arbitrageurs. My honest opinion is that all recently developed instruments are harmful and that the typical activities of law abiding financial operators destroy value. I don’t see any downside risk of excessive regulation basically because I think that, on balance, the allegedly undesirable side effects are desirable.

It should be possible to guess that I don’t think that “market liquidity” is a good thing. I use quotes as I would define assets as liquid or illiquid and markets at thick or thin. The issue is whether one can quickly buy or sell a large amount of an asset without causing its price to shift much. I believe (without proof as usual) that assets are liquid when trading volume is high. Thus my question becomes whether high trading volume is a good or a bad thing.

A sudden decline in the liquidity of assets can create problems as firms can’t unwind leveraged positions without extreme market disruption. If the assets had always been illiquid, those leveraged positions would never exist. I think that would be a good thing.

Now there is a class of arguments that rational investors will take highly leveraged positions to profit from asset miss pricing and that this is socially desirable as they will drive asset prices towards their fundamental values. It is hard find these arguments convincing given the enormous increase in asset price volatility which has accompanied the enormous increase in gross long positions and gross short positions not to mention the huge increase in trading volume. My sense is that the average super smart highly trained trader is driving asset prices away from fundamentals. Thus I think honestly reported legal trading strategies are, on average, worsening the quality of the signals financial markets send to the real economy.

In particular, hedging strategies require constant trading. They are not feasible if there are significant bid ask spreads. The scale of hedged positions is limited if assets aren’t perfectly liquid as the hedging trades drive prices against the hedger. So ? There is no huge amount of trading by people who don’t follow hedging strategies such that a huge amount of hedged trading is required to balance it. Rather the huge volume consists of roughly equally sophisticated traders, all of whom know how to hedge, taking bets against each other. The cure is the disease.

It doesn’t have to be this way. I would be possible for trading volume to be tiny compared to current volume — the way it was in the 50s. Trading for reasons other than perceived asset misspricing would be very rare. There would be investors who save when young and dissave when old, investors who liquidate financial assets to make downpayments on houses and maybe a tiny bit of investors hedging their labor income risk (has anyone ever met anyone who ever did that ?). Now the most archaic market in which there are specialists who sell for one eighth of a cent more than they pay when they buy would be a tiny tiny problem for life cycle investors. If people aren’t trying to beat the market, liquidity barely matters to them.

As noted above, if no one tries to beat the market no one gathers information on, say, firms prospects. That would imply that price earnings ratios of shares would depend on rough guesses. That wouldn’t be strong form efficient. I don’t think any sensible person can look at the history of asset prices and doubt that the old market in the 50s was closer to a strong form efficiency.