By way of an initial reply to Brad's Prologomenon:
The saver has his greed and has his fear
He wants it in an overnight account.
The borrower, though, wants the full amount
and wants to use it for a dozen years.
And so a broker magically appears
to offer stock, and bid at a small discount
and make a turn; but they must never miscount.
Liquidity providers cannot clear
a market which displays adverse selection.
Smart traders bearing lemons cause a drought.
Markets don't just exist; they must be made
So dealers churn their books in self protection
And gamblers wash the information out.
They also serve who only sit and trade
What am I on about? Well, basically the "No trade theorem" of Milgrom and Stokey.
Basically, if all you have are informed traders, then you don't have a market. It's similar to the market-for-lemons problem - the simple act of offering to sell a stock reveals that you have information that there's something wrong with it, and so nobody is going to trade with you. You have to have at least some traders who are motivated by liquidity considerations (ie, they have a gas bill to pay so they are selling stock, or they're just received an inheritance so they're buying) or who are just "noise traders", for the whole thing to work.
This is market microstructure - the study of *exactly* how trading progresses between informed parties in securities markets. Basically the conclusion is that market-makers (the professional intermediaries) lose money when they deal with informed counterparties, and make money when they deal with uninformed ones. And, since informed counterparties do not wear a badge identifying themselves as people to avoid, basically all the insurance industry apparatus of adverse selection can be theoretically brought to bear; as with the excess on an insurance policy, a large proportion of the cost of dealing in shares is basically the result of the need to overcome an information asymmetry.
I don't think I'd be exaggerating if I said that more than fifty per cent of the salaries and bonuses paid on a trading floor are basically to do with the business of making sure that you don't lose more trading with smart punters than you make dealing with mug punters. There are certain hedge funds that you always lose money when you take the other side of their trades - you deal with them a) because they rebate some of the profits they make out of you in the form of a commission payment, and b) because having their order flow means that you have some of their information, which means that you are now a smart counterparty with respect to the rest of the market, for a while.
And this is another reason why dealing in emerging market securities is so damnably expensive - the markets are smaller, and in general the only people dealing in them are people who have a reason to believe that they know what they're doing. Who are, of course, exactly the kind of people you don't want as your counterparty.
As far as I can tell, Brad's view is that there are natural, good liquidity traders (basically life cycle savers), and that this ought to be enough in the way of uninformed trading for anyone to be getting on with. I don't think that can be assumed at all though. Liquidity - the ability to have instant access to your savings even though they are invested in long-term capital projects - is a really valuable and popular thing, and people are prepared to pay a lot for it. And if it's a really valuable thing, then the market will find a way of paying for it (the original DeLong//Shleifer/Summers "noise traders" paper showed how without intending to, the market can find a way to pay positive feedback gamblers for their liquidity). I would not want to defend any particular level of mindless gambling as optimal, but some is better than none, and I don't think it can be flagged as a per se undesirable.
(also - measuring "good" trades as a proportion of the total turnover is a screwed metric. Most of the volume on any given day in nearly any given market is inter-dealer, and simply reflects the annoying tendency of end-users to turn up placing orders that are larger than the risk-bearing capacity of the firm that they placed them with. Inter-dealer volume of this sort is usually uninformed, except in those cases like the hedge fund I mentioned above when it is. But informed or otherwise, it's just necessary inventory management of the sort you get in any market and should be exed out of the market size for purposes of deciding how much trading is of what type).
Isn't there another very important motive for selling - not so much liquidity as in "I am short of cash", but just that eventually it's all worthless unless you spend it? In the same way as there's no point running a trade surplus forever.
ReplyDeleteA big difference between them is that the liquidity-constrained are relatively insensitive to price (they don't want 2% more or less, they want CASH) and primary sellers are price-sensitive. (I'm working on your point that markets are moved by those actors who are willing to buy or sell at any price.)
Similarly, people who are convinced that Knutsford plc is going to the STARS! or who want out so they can move to Dorset and stockpile ammo because The Animals Are Coming! (copyright Ron Paul) aren't motivated by the spot price as such.
Rather, they are motivated by the prospect of future capital gains or losses that dwarf intra-day movements or differences in rival brokers' commissions.
If you take this to its logical conclusion, I'm afraid we'll just have to occupy everything:-) As it implies that the fundamental driver of the stock market is decisions that are more likely to be wrong than right.
"A strange game. The only way to win is not to play"
I always remember being taught was the main component of the bid/ask spread, not sure if it's true.
ReplyDeleteIs it not possible for fully informed traders to have differing views on the future, or is perfect knowledge of the future part of being fully informed?
I don't think two fully informed traders can have different views, but I don't think I can prove it.
ReplyDeleteAlex - a few interlaced points:
1. Yes, the liquidity motive is usually just about wanting to buy something - if I were to want to buy a sports car I would be "short of cash", because I don't have a hundred grand and would need to sell some assets to get it.
2. But because most liquidity motivation is actually fairly weak in terms of urgency, liquidity traders aren't wholly price insensitive. If they have an idea of fair value, then they will be prepared to pay a certain amount of premium or discount to it, as the price of immediacy in execution, but no more. (I totally agree with you about how the rational process falls apart in bubbles though).
3. So the intuition here is that what the noise traders supply is *noise*. The fact that your average buy or sell order is likely to have pretty low information content, and is likely to have been put in by someone who will accept execution within x% higher or lower than the information he actually does have, is what makes it possible to trade at all. If there are too many sharpies or insiders trading on good information, you don't have a market.
(there will be a follow up post on this last point and the general theme of "crimes against the market", which will discuss what's really bad about letting John Paulson structure your CDO for you. Basically, there's a social convention that we're all going to act as if we're dealing with a noise trader unless specifically warned otherwise. Attacks on that social convention are attacks on the viability of the market itself.
"I don't think two fully informed traders can have different views, but I don't think I can prove it."
ReplyDeleteSure they can! Since there can be reasonable and rationally underdetermined differences about the right way to evaluate a body of evidence, weighting of criteria etc.
D^2: Perhaps I could rephrase the distinction as between discretionary and forced trades. If you want to buy a sports car, or derisk 3 years before retirement, whether you do it this week or next is immaterial. Price is all.
ReplyDeleteIf you need to make a margin call, though...or if you think stock X is going to the stars and you'll miss the bus if you don't act now, well, what matters is immediate execution.
Given the principle, which we both accept, that price-insensitive actors move the market, this implies that unreason rules, a fish.
There's also an interesting distinction between general and specific risks. If you want to get out however many years before retiring, it's because there is always a general risk of a crash. However, the chance that it shows up tomorrow is fairly low. Actors driven by general risk or reward are discretionary, actors driven by specific risk or reward are forced.
Yes, but remember that it's a pretty odd (and eminently exploitable - this is the root of the proverb that "a crash is when money goes back to its true home") situation for the price insensitive actors to be piled up on one side of the order book. For every person de-risking to go into retirement, there's usually a new sprog opening up a new pension account.
ReplyDeleteMost of the time, price-sensitive actors are dominating the order book - that's why fundamental analysis works, most of the time. Sometimes price-insensitive actors dominate - that's why technical analysis works, some of the time.
Nearly all the time, it's not totally clear who's in control of the order book, but it's reasonable to assume that the small minority of dangerous people who are *both* price-sensitive *and* well-informed, aren't. That's why market-making is possible.