The liquidity canard

August 25, 2009

It’s often said on Wall Street that the more liquidity there is in a given market, the better things are for investors trading stocks, bonds or commodities. And while there’s a lot of truth to that, there are times when too much liquidity can be just the wrong tonic.

After all, Wall Street’s churning-out of one subprime-mortgage backed security after another pumped a lot of liquidity into the U.S. housing market, and that simply encouraged a lot of reckless — even fraudulent — lending.

That’s why I’m not impressed with the securities industry’s main defense of computer-driven high-frequency trading, which essentially is that all this lightning-fast trading provides liquidity and better prices for investors.

It’s a hard argument to swallow when you consider that many high-frequency trading programs are simply engaged in trading the same stock thousands of times a day in less than penny increments. Now maybe all those rapid-fire automated trades are getting better prices for some investors. But when a broker excessively buys and sells securities to generate higher commissions, it’s called churning, and that can result in an investor lawsuit or a regulatory sanction.

Indeed, when fast-fingered day traders were doing much the same thing as today’s high-frequency traders — albeit without the benefit of a sophisticated algorithmic program to guide them — Wall Street’s biggest firms were quick to dismiss them as either amateurs or rogues who were causing unnecessary volatility in the price of tech stocks.

So with critics raising legitimate concerns about the potential of a rogue algorithm sparking an unintentional market meltdown, the notion that high-frequency trading is OK because it creates more liquidity simply won’t wash.

If the main purpose of all that extra liquidity is to simply make fat profits for high-frequency traders at Goldman Sachs, UBS, GETCO, Citadel Investment Group and Interactive Brokers, that’s liquidity the markets can do without.

A similar and equally indefensible liquidity objection is being raised by some on Wall Street to a column I wrote on Monday, when I suggested that regulators prohibit derivatives dealers from being able to reuse and redeploy some of the $4 trillion in collateral that’s been posted by customers as guarantees on derivatives trades.

Investment firms claim if they cannot redeploy this collateral and use it as they see fit, the costs associated with derivatives will increase, and that will hurt customers.

The investment firms are probably right in their assessment. The cost of doing derivatives transactions would go up if regulators close the door to one way that Wall Street firms have been making money off these sophisticated financial instruments. But that’s OK. One of the problems with derivatives is that the true costs and risks associated with these products often were concealed. Risky financial instruments should carry far higher transaction costs.

Adding liquidity to markets is no panacea. It doesn’t make risk magically disappear, nor does it guarantee that all investors will be dealt with more fairly.

Sure, liquidity may beget liquidity. But it also may lead to unintended drowning.

6 comments

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[Quote]
I’m not impressed with the securities industry’s main defense of computer-driven high-frequency trading, which essentially is that all this lightning-fast trading provides liquidity and better prices for investors.

It’s a hard argument to swallow when you consider that many high-frequency trading programs are simply engaged in trading the same stock thousands of times a day in less than penny increments. Now maybe all those rapid-fire automated trades are getting better prices for some investors. But when a broker excessively buys and sells securities to generate higher commissions, it’s called churning, and that can result in an investor lawsuit or a regulatory sanction.
[End of quote]

True, but there is an important distinction between HFT and brokers. Most high frequency traders are not brokers. Brokers execute trades on a clients behalf and charge a fee for the service. If a broker does a sloppy job executing your trades, it doesn’t follow that the high frquency trader is at fault.

[Quote]
So with critics raising legitimate concerns about the potential of a rogue algorithm sparking an unintentional market meltdown, the notion that high-frequency trading is OK because it creates more liquidity simply won’t wash.
[end of quote]

A rogue algorithm would be shut down very fast because it would hit its exposure limits. There a number of ways these limits are enforced. For example some exchanges enforce these directly.

[quote]
Investment firms claim if they cannot redeploy this collateral and use it as they see fit, the costs associated with derivatives will increase, and that will hurt customers.
[end of quote]

Not sure what this has to do with HFT if anything.

It would also be nice to see some reporting of the benefits of HFT. HFT is widely believed to have reduced trading costs for individual investors.

In the real-estate example the problem was liquidity was only on one side, the side of buying and lending, and that pushed prices up. There wasn’t a corresponding pressure of liquidity on the other side because you can’t instantly create thousands of homes to sell and it’s hard to short real-estate.

Anyway the one-sided liquidity was just a symptom of too much money on the side of buyers. The liquidity didn’t create the problem itself.

Equity markets have well-matched liquidity on bid and ask side of the market and high-frequency trading is contributing to liquidity on both sides. The real-estate analogy doesn’t work.

But no matter how good the liquidity is, if a rogue algo is likely to cause a meltdown then we *should* be concerned. But there’s little room for concern:
Most algos dampen volatility rather than create it
Most algos are relatively market neutral so they can’t push the market far one way or the other.
If an algo unintentionally creates volatility it will be taken to the cleaners by the regular algos (as well as human traders).
Consequently, algos are written to have many circuit breakers to shut them down if things look weird.

And as we have seen during the recent meltdown, algos were stable during the crisis and continued to provide liquidity throughout.

Regarding churning: if a broker abuses his privilege and overtrades my account that’s called churning. If a high-frequency trader has high commissions but makes money anyway there’s no abuse of privilege.

Posted by Steve | Report as abusive

Well articulated Steve, this liquidity thing has been bothering me too, also: ‘Risky financial instruments should carry far higher transaction costs’ – risk should be read in conjunction with return, not tx costs. Also, the collaterals – who receives the returns when held in proper trust ? (if it earns interest only, I would query my broker…)

Posted by Hour glass | Report as abusive

[...] returning to the topic of HFT providing liquidity, Reuters’ Matt Goldstein had some prophetic words in this context: “I’m not impressed with the securities industry’s main defense of [...]

[...] notion that high-frequency trading is OK because it creates more liquidity simply won’t wash.  (Matthew Goldstein also Zero [...]

Matthew,

Your concluding remarks are on target. This type of HFT is toxic liquidity. I maintain that Gresham’s law (bad money drives out good money) will apply to liquidity. As long as toxic liquidity remains, it will continue to hurt the real money traders and reduce volume.

Posted by Institutional Trader | Report as abusive

[...] that have attracted large American firms like Getco and Madison Tyler. …   The liquidity canardIf the main purpose of all that extra liquidity is to simply make fat profits for high-frequency [...]

in general a checking account is more liquid than a savings account because there is a little less hassle to removing your money from it. If the government declares a bank holiday you may be out of luck. It has happened in the past.
http://www.goarticles.com/cgi-bin/showa. cgi?C=2281001

Posted by collinbell99 | Report as abusive

We’re beginning our retirement savings, and are not sure why our money market isn’t the best place for the money; I assume for tax reasons.
http://ezinearticles.com/?Bowtrol-Colon- Cleanse-Review—Does-Bowtrol-Cleanse-Work  ?&id=2926555

Posted by collinbell99 | Report as abusive