Liquidity and the Market-Making Function

by George Hatjoullis

When the Nikkei rallies 5.9% overnight I am concerned. This is a huge market however you measure ‘huge’. This should not occur. My only explanation is that liquidity is seriously impaired. This is entirely down to the regulators throughout the globe. The response to the 2008 financial crisis (which actually began August 2007…I was there) was to severely curtail the ability of investment banks to take proprietary risk. This completely missed the real cause of the crisis which was rooted in the packaging of financial products. It had the feel of alchemy to anyone capable of free thought, though free thought is quite hard in context. Basically poor credits were packaged to produce a AAA financial product. The assumptions were clearly nonsensical yet few questioned and those that did were looked at as if they were flat earth advocates. These rubbish products were then distributed throughout the system and the rest is history. It had nothing to do with proprietary trading. It had to do with poor ethics and stupidity.

In the aftermath banks were regulated and bullied into reducing their proprietary risk taking. This may have adversely affected liquidity. Two market functions of investment banks (there are others) is primary and secondary market activity. Primary is about bringing securities to market and secondary involves the day-to-day trading. The secondary trading used to ensure liquidity. The market maker would quote a bid offer spread and a size and take the risk on the banks book. The seller did not need to wait for the broker to find a buyer. The bank made a price and this was available immediately. Many banks doing the same thing ensured lots of liquidity and keen bid/offer spreads. However, the bank would often find itself net long or short and so taking proprietary risk. It might try to hedge this overnight but such hedges were rarely perfect. There was always a residual. To manage this residual, the banks developed aggregated books which were managed by a senior risk taker. From here the proprietary trading function grew as a profit, and risk, centre.

Banks often incurred losses in the proprietary trading function. The most serious that I was ever a part of was at an investment bank during the 1994 bond market debacle. However, even this did not bring the bank down. Proprietary trading losses rarely threatened the existence of the banks even in the worst of situations. So it came as a surprise (to me) when after the 2008 crisis proprietary trading was curtailed. There is a case for curtailing this area of risk and return but not at the expense of the market making function. This rather ill-considered regulatory trend seems to have killed liquidity in a number of markets and the loser is the man in the street. How so?

The demise of the defined benefit pension in favour of defined contribution has left many trying to meet their retirement income goals via investment. Most will be using fund platforms. These platforms generally price around lunchtime in local time and quite often orders must be given the day before or even earlier to effect a buy or sell order. You could have given an order yesterday to buy a Japan fund thinking it was a good level to enter this market. You would have been executed at 5.9% higher than you expected. This is not good.