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Increasing Trading Frictions Increases Market Liquidity?

With market volatility that has only been witnessed during the Great Depression, it seems that we should all be asking some questions.

  • Is the volatility necessary?
  • Are large valuation fluctuations  destructive or constructive for the capital markets?
  • Did market technical factors change?
  • Did changes in policies create even more volatility?
  • Derivatives to blame?
  • Do investors get rewarded for taking extreme volatility risk?

I think it is valuable to address all of these questions, and I have often put thought to whether the new set of market participants create volatility through hedging programs.  For now, I would like to focus on the idea that missing policy is partly to blame.

In my past gripes I have considered it absolutely ridiculous that the uptick rule was removed after 70 years with little proof of concept.  The economists at the New York Fed have added some further color regarding these types of restrictions and/or circuit breakers.  Gara Afonso asks the question, “When Do Trading Frictions Increase Market Liquidity?

Her main argument falls under one specific market scenario:

..suppose that a significant number of investors who were holding this asset decide to sell it. If the increase in the number of sellers is matched by a rise in the number of buyers, trading costs in the OTC market would fall. However, if the increase of investors concentrates solely on one side of the market (the sell side in this case), there will be many sellers per buyer, and hence it will be more difficult for a seller to meet a buyer and negotiate the terms of the transaction. In other words, as the market becomes congested, transaction costs will increase. However, since investors can choose between different investment opportunities, if trading in this market becomes more costly, they may prefer other investments. As fewer buyers are attracted to this market, the proportion of buyers to sellers becomes even more unbalanced and trading becomes even more costly.

In one-sided markets that tend to play key roles in financial distress, reducing frictions to facilitate trading may, paradoxically, diminish market liquidity and make investors worse-off. Why? In a market where many participants want to sell and few are interested in buying, reducing frictions and facilitating trade make it easier for a buyer to meet a seller and to purchase the asset (this may lead to an increase in trading volume). However, at the same time, as a buyer acquires the asset (and the pool of potential buyers shrinks), the ratio of remaining buyers to sellers in this market becomes more unbalanced. This leads to higher trading costs, lower prices, and, ultimately, lower liquidity (measured by the price discount). As transaction costs rise and liquidity evaporates, the market becomes less attractive to potential new investors. Also, as transacting becomes more costly and illiquidity rises, investors who hold the asset in their portfolios as well as those who are trying to sell and exit the market become worse off. In this scenario, reduced frictions can decrease total welfare.

You might have to read that last paragraph a few times for it to make any sense, but the basic idea is this: if there are a ton of sellers and a limited number of buyers then allowing each incremental trade to occur reduces the number of buyers so that the market becomes even more one sided.  If the market becomes more and more one sided, then the avalanche continues to fall and the price gaps further downward.  As the price gaps downward, even more buyers step away from the market as they find the risk to great that the asset will fall further.

This has happened quite a few times – 1987, many times in 2008/2009, and specifically on May 6, 2010 flash crash.

I doubt there is any one item that has created the market volatility, but I do believe there are a number of factors driving our historically volatile markets.  Yes, the economy is/was bad, the housing market crashed, Europe is in shambles and lots of debt needs to be dealt with…but if you watched the markets trade on May 6th and some of the other gapping days over the last few years with no news, then you know to be asking questions as well.

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