In favour of much less trading
It was front page news in the Wall Street Journal. For three long hours last week, there was no trading on the Chicago Board Options Exchange, the home of S&P 500 stock index options and the Vix volatility index. The Journal quoted a trader: “It was very, very unnerving”. Risks went unhedged. Experts worried about the effect of a more grievous software fault on an even more important exchange. What would happen then?
Almost nothing. Imagine a worst case scenario: a hacker closes down all the exchanges for a full month. All portfolios of stocks, bonds, options, futures, currencies and commodities are exactly the same on June 1 as on May 1.
What would the outage change? The prices at the end of the “exchange holiday” would presumably be about the same as they would have been otherwise. The lost income of brokers and traders with superior insight or information would be matched by the foregone losses of their counterparties. As for the economy, a few new issues of bonds and shares would have been delayed a few weeks, but the losses would be more than matched by gains: the absence of frenetic trading would remove a significant distraction for business people.
If that sounds like an improvement, take a miniscule modicum of comfort. Regular financial market holidays are likely to be introduced in the hyperactive foreign exchange market. EBS, which runs one of the big forex trading platforms, plans to force traders to take regular breaks. Admittedly, the R&R will only last a few milliseconds. Instead of dealing with orders as soon as they come in, the platform will wait that long to match buyers and sellers.
Traders and theorists of financial markets usually argue against all trading holidays, whether forced or voluntary, long or tiny. They say liquid financial markets are good for the economy, because ease of selling both encourages savers to buy in the first place and allows them to limit losses. No one should have to wait any longer than absolutely necessary to finish a desired transaction.
That is wrong, for two reasons.
First, liquidity is not an investor’s right; it’s a potentially dangerous privilege. The reality is that as soon as money is invested, it is committed to the capital side of the economy and tied up forever. It is turned into buildings, machines, inventory, roads, cables, software, films, training courses. Whether or not the assets provide a return, and however long they last, they cannot be unmade.
That is an inconvenient truth, and the much of the financial system is dedicated to getting around it. Banks offer withdrawals, bonds are repaid and markets permit portfolio liquidation, as if history could move backwards as well as forwards. For society as a whole, it’s a good system, even a great one. It allows the young to borrow, the middle-aged to save and the old to spend.
But the arrangements are fundamentally fragile, because they are based on a sleight of hand. The sale of a financial asset, whether to cash in totally or to trade for another one, corresponds to nothing in the real economy. The system is designed to deal with only a limited quantity of such transactions. Excessive liquidity is an abuse of the privilege, turning the financial system into an economic risk factor.
Second, liquidity encourages the dangerous chimera of safe investing. In reality, the financial system cannot be safer than the stock of investments, and investments are always claims on a necessarily uncertain future. At best, the existence of financial markets can increase some investors’ safety, but that gain that always comes at the cost of less safety for their counterparties.
For safety-searchers, increased liquidity ultimately makes this trade-off less attractive. That may sound counter-intuitive, because ample liquidity is needed for “dynamic hedging” and many other techniques used to make portfolios safer. However, easier selling leaves the market more subject to emotions, which are more volatile than facts, and to trend-followers, who almost always push prices farther than reality dictates, whether the market momentum lasts for milliseconds or months. Increased liquidity leads to greater price volatility – and more expensive hedges.
Less trading is a good idea, but many investors will be appalled. They are basically speculators, who like making more trades just as gamblers like making more bets. For the real economy, though, less liquid markets would do no harm and could discourage the financial bubbles which often end in economic busts.
Financial transaction taxes may decrease liquidity. A more direct approach is to reduce trading frequency. Why not stretch out the millisecond holidays in foreign exchange into once-daily price fixings in all markets? Think of it as a version of work-life balance: less wasteful work in finance, more time for genuine economic life.