Economics and similar, for the sleep-deprived

A subtle change has been made to the comments links, so they no longer pop up. Does this in any way help with the problem about comments not appearing on permalinked posts, readers?

Update: seemingly not

Update: Oh yeah!

Monday, October 31, 2011

On Liquidity

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).
6 comments this item posted by the management 10/31/2011 02:56:00 PM

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