Economics 16: Financial Markets

by George Hatjoullis

The Economics series has tried to introduce the uninitiated to the workings of a market based economic system. The most important markets in this system are the financial markets. Oddly enough one will find scant attention is paid to such markets in economics textbooks. Indeed even finance texts offer little insight into the essential features of financial markets and how they feedback and interact with the so-called, ‘real economy’. Aspects of the neglected features of financial markets have been covered in the various Gestaltz blogs and the next several installments of the Economics series will bring together and develop these aspects of financial markets and their interaction with the real economy.

The popular perception of financial markets is that they are casinos in which rich people gamble. Politicians and journalists when pursuing their respective agendas promote this perception. It is not the case. There are two important differences between casinos and financial markets. First casinos (and other gambling institutions) create risk in order for people to gamble. If they did not create it then it would not exist. Second, the outcomes arising from casino-generated risk conform to a well-defined probability density function. You can calculate the odds, if you have the necessary information. Casinos and other gambling institutions serve only as entertainment.

Financial markets provide each agent with a means to buy and sell risks, and the corresponding possibility of reward, which arise from the normal course of economic life. The risk of your house burning down exists whether you buy house insurance or not and whether a market for such insurance is available. The odds of your house burning down cannot be calculated precisely. There is always some degree of uncertainty about the nature of the process generating the risk. Financial markets allow agents to cope with the inevitability of risks and the uncertainty surrounding the nature of these risks. Financial markets serve an economic purpose beyond entertainment, unlike a casino.

There are two broad categories of market, primary and secondary. An initial public offering of a share (IPO) takes place in a primary market. The Royal Mail privatization was a primary market activity. In order to sell your shares of Royal Mail you access the secondary market. The secondary market enables the continuous trading of financial instruments, such as Royal Mail shares. If the shares of Royal Mail could not be traded in a secondary market, many people would not have applied. The existence of a secondary markets confers ‘liquidity’ on the instruments brought into existence through the primary market. Liquidity, as was discussed in Economics 15, is the ability to convert an asset into money.

Financial instruments are contractual arrangements between two or more parties. Everybody deals in financial instruments. Car insurance is a financial instrument. The car insurance buyer agrees to pay a set amount to the seller for a predetermined period and in exchange the seller agrees to indemnify the buyer from the financial consequences of specified outcomes. A credit default swap (CDS) is exactly the same (except that the specified indemnities do not relate to cars). Individuals cannot trade car insurance contracts in a secondary market whereas CDS are traded in secondary markets. It is however possible for an insurance company to package up car insurance contracts and sell claims to the cash flows, and liability for the associated risks, to third parties. This is called securitization. The packages of car insurance contracts might be traded in a secondary market. Financial instruments are simply contractual arrangements that serve some economic purpose. They are generated through the primary market and traded via secondary markets, which confers liquidity on these contracts. Securitization is simply the packaging up of individual contracts usually for the purpose of enhancing the liquidity of the underlying contracts.

Insurance is not the only financial instrument used by individuals. Previous blogs have introduced the concept of saving or exchanging claims on current GDP for claims on future GDP. There has been regular mention of ownership of the means of production. Ownership is widely distributed through the use of financial instruments. Individuals own shares, bonds and bank deposits. They can own them directly or through collective ownership instruments (or funds). These instruments directly or indirectly confer ownership of the means of production on the holders. The terms and conditions of the ownership are specified in the contract. Instruments such as shares or equity confer a share of the success or failure of the enterprise. In contrast instruments such as bonds and bank deposits involve a fixed claim by the holders on the enterprise irrespective of the degree of success or failure. Ownership is only obvious if the enterprise fails and is resolved (wound up). The contract will specify the nature of the claim the holder of the instrument has on the residual assets of the enterprise. In the absence of such instruments it would be difficult for individuals to save for when they could not or chose not to work. It would be difficult for enterprises to raise funds to finance themselves. It would be difficult for economic activity to occur in the modern economy.

The liquidity role of secondary markets is vital. The ability to convert any financial asset to money is key to the willingness to hold such assets. It enables individuals and enterprises to continuously and cheaply adjust asset and liability portfolios to suit ever-changing circumstances. Market liquidity has several aspects. A liquid market must be able to digest large quantities of securities without causing ‘material’ price movements. Liquid markets have minimal differences between the buying price (bid) and the selling price (offer). Prices in liquid markets adjust ‘continuously’ and ‘smoothly’ as new information relevant to the valuation of the instrument being traded becomes publicly available. In economics 15 we discussed why liquidity is vital for the banking system and how the role of the central bank is essentially to ensure that solvent banks have sufficient liquidity, albeit at a price. The question that arises is how does a secondary market ensure it offers the necessary liquidity?

There are two broad categories of organization in secondary markets, the broker and the market maker. The broker market acts as an organizing framework for matching buyers and sellers. The broker is the ‘agent’ that brings the buyer and seller together. The broker does not buy or sell but merely facilitates. Liquidity is determined by the number of buyers, and sellers, making themselves known at any point and the range of prices and amounts at which they will trade. Liquidity can be variable. The market maker, as the name implies, acts as principal and will quote a bid to a seller and make an offer to a buyer for whatever size. The market maker commits capital to the process of making a market because the activity could involve losses. The market maker attempts to keep the net holding of the asset close to zero and to make money from the difference between the bid and the offer. However, this is rarely possible and the market maker inevitably is left with net long or short positions. The market maker adjusts prices continuously as net positions accumulate, partly to discourage further buys (sells) and to encourage more sells (buys). A market served by market makers is typically more liquid.

Another category of principal is the speculator. Ironically, although the speculator is motivated to make money by predicting the direction of price moves, the net effect is normally to enhance market liquidity. As long as there are diverse opinions on the direction of prices then the activity of speculators normally mimics that of the market maker and effectively adds capital to the process of making prices. The speculation activity only becomes problem if too many speculators simultaneously have the same view on the direction of prices and the direction of activity become one-way. This can create discontinuities in pricing and force destabilising behaviour. If sufficiently severe, and other conditions apply, such instability can cause a market to fail. Market failure is the cause of financial crises.

Market failure occurs when either buyers or sellers substantially withdraw from the market. Transactions in any size become impossible and the quoted price becomes meaningless. It is usually the last price at which someone traded and need not bear any relation to the price at which one could actually trade a meaningful quantity. Unfortunately, the price might still be used to value holdings of the asset in question and this might lead to further economic decisions and actions that could make the dislocation worse and intensify the problems. For example, extreme price falls following small sales could result in large market-to-market losses that might require the holder to liquidate the holdings. Any attempt to liquidate could prove impossible but drive prices even lower, inflicting the problem on another set of holders. If the problem becomes sufficiently widespread it might trigger concern that some entities are no longer solvent and thus discourage trading with some counterparts, whatever the financial product. Entities incurring mark-to-market losses in the original failed product might sell holdings of otherwise perfectly well functioning asset classes to cover the losses (because they can). In this way the market failure could be spread to other markets. Before you know it you have financial crisis that is impacting the ‘real economy’.

Although there is a particular class of market participants that fit the category of speculator, speculation is an element of all financial market activity. It is this reason that markets have been conceived as casinos in the popular perception. Financial markets can make you very rich or very poor and in ways that are often hard to fathom let alone predict. However, for markets to fail, expectations of price changes have to become predominantly in one direction. For market failure to become a crisis there must be an economic significance to the price in terms of knock on decisions.

For example, assume all banks hold government bonds and these bonds are always marked at the maturity value of £100 each on the balance sheet. A market failure in these bonds has no immediate impact on the banks because it does not affect their solvency. If the government fails to repay at maturity then this is different issue but that may be some time in the future. If the banks need liquidity they need not sell the bonds if they are eligible as collateral with the central bank. However, if the banks are forced to mark the bonds to a price determined in a failed market it may impact solvency and trigger corresponding behaviour that makes the situation worse.

The most important take from Economics 16 should be that speculation does not cause financial crises. In the normal course of events it enhances market liquidity. Speculation may become a problem if many market participants have the same point of view and the market becomes a little lopsided. Interestingly enough this is less likely if volatility is high. Price volatility is the chance of price movements in either direction on a given day. If volatility is high then the chance of a move against you on any given day is high. This serves two important roles in containing speculation. First, speculative positions relative to capital are kept lower than they might be because of fear of loss. Second, it encourages a two-way market because it is possible to make money being short or long and it is rarely obvious which way markets will move in the short-term. Crises usually emerge after a period of unusually low volatility with prices moving predominantly in one direction (as rule, higher). This creates a false sense of security and encourages greater risk exposure. Such situations are very vulnerable to shock and one thing that is certain is that a shock will, sooner or later, materialize. Looked at this way, the biggest contributors to crises are the authorities, when they act to dampen volatility. Economics 17 will explore market failure in more detail.