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.

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