“Liquidity Is The Last Refuge Of The Scoundrel”
Joseph Saluzzi (jsaluzzi-at-ThemisTrading.com) and Sal L. Arnuk (sarnuk-at-ThemisTrading.com) are co-heads of the equity trading desk at Themis Trading LLC (www.themistrading.com), an independent, no conflict agency brokerage firm specializing in trading listed and OTC equities for institutions. Prior to founding Themis, Sal and Joe worked for more than 10 years at Instinet Corporation, pioneers in the field of electronic trading, and at Morgan Stanley.
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Liquidity could be one most overused and misunderstood terms on Wall Street. Liquidity is a term that is usually rolled out when self-interested parties are looking to defend their highly profitable business models. How many times have you heard the HFT industry say “we provide liquidity”? We are also seeing a lot of “liquidity” comments from the big banks who are trying to squash the Volcker rule. The banks are warning that if you force them to shed their proprietary trading areas then the market will suffer because of a “lack of liquidity”. But the question becomes, how much liquidity is actually needed?
In a comment letter on his own rule, Paul Volcker addressed this liquidity issue:
“At some point, great liquidity, or the perception of it, may itself encourage more speculative trading, even in longer-term instruments. Presumably conservative institutional investors are tempted to turn over positions much more rapidly, at the expense of careful analysis of basic values. In the light of events, careful consideration of the benefits and possibly damaging consequences of increased liquidity has become the subject of new studies and commentary by economists and regulators. A consensus may be developing that beyond some point, little or no public benefit may be evident.”
Volcker also addressed the liquidity issue at a recent event (15 minute mark of video) with John Bogle, the Vanguard Group founder:
“Liquidity is partly a state of mind. Is there such a thing as too much liquidity that is misleading people into investment behavior that is damaging to the economy?”
John Bogle then added his opinion on liquidity:
“Samuel Johnson had a saying that Patriotism is the last refuge of the scoundrel. And I have an idea that liquidity is the last refuge of the scoundrel.”
“All this trading creates nothing, creates no value, in fact, subtracts from value.”
“IPOs and secondaries amount to about $200 billion per year, but last year we had $40 trillion of trading in the US securities. There is 200 times as much speculation as there is investment ..or investment accounts for 0.5% of the function of Wall Street.”
Lord Adair Turner, chairman of the FSA, questioned the value of “liquidity” in a 2010 speech :
“A reasonable judgement on the economic value added of increased liquidity does deliver benefits but subject to diminishing marginal utility, and the increased financial speculation required to deliver increased liquidity creates an increasing danger of destabilising herd and momentum effects, the larger pure financial activity becomes relative to underlying real economic activity.”
Was the oil market liquid on Monday when an algo decided to quote blast it? Was Amazon liquid yesterday when a headline crossed that caused the stock to drop 3% in seconds only to rebound minutes later? Was the stock market liquid in the last 20 minutes of trading yesterday as shorts scrambled to cover on another Greek rumor? Liquidity is partly a state of mind.
We hear all too often how today’s market is filled with liquidity but yet many traders that we speak to don’t seem to think that the markets are very liquid. All too often they enter the market, only to watch the liquidity that they thought was there disappear right before their eyes. The next time you friendly neighborhood bank or HFT tells you that he adds liquidity for the good of the market, let him know what he could do with his liquidity.
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February 24th, 2012 at 10:14 am
“‘ IPOs and secondaries amount to about $200 billion per year, but last year we had $40 trillion of trading in the US securities. There is 200 times as much speculation as there is investment ..or investment accounts for 0.5% of the function of Wall Street.’ ”
Is this accurate? 99.5% of Wall Street is nothing more than a poorly regulated casino? Wow, you just can’t be too cynical can you?
February 24th, 2012 at 10:19 am
And don’t forget Keynes’ comment on liquidity:
This is the inevitable result of investment markets organised with a view to so-called “liquidity”. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.
February 24th, 2012 at 10:37 am
Liquidity= add more zeros to the fantasy fiat bowl.
Those zeros buy a lot of food stamps in the real world.
February 24th, 2012 at 10:38 am
I have a world of respect for Joe Saluzzi.
He has stuck his neck out numerous times on CNBC to inform the public about the HFT mass scandal, despite the rest of CNBC’s staff making the case in favor of HFT (on behalf of Goldman Sachs, JPM et al).
HFT’s DO provide liquidity in the form of tighter spreads (bid/ask), but what they take away is much greater…it’s just impossible for 70% of all trading volume to be out of the market by the end of the day without negative ramifications.
Like playing a night of poker, winning half the games, then at the end of the night when it’s time to cash your chips from the winnings you learn 70% of the pot was fake.
I have been making the argument against the ridiculous claims of “provides liquidity” since watching two executives from a flash (order) firm interviewed by Maria Bartiromo about 3 years ago who just kept blindly repeating the phrase “provides liquidity” in response to any mentioned objections.
Flash orders are nothing but stealing money directly from traders (arguably, so are many HFT strategies) by allowing players in the proverbial poker game to peek at others hands before placing bets, atop having the power of HFT to manipulate price, volume and excite head-fakes.
February 24th, 2012 at 10:45 am
If you want a place to dump your stocks, it is thought… but wait. If you want to make an INVESTMENT in a liquid security, a “position,” THINK about it first. The easier you can get out of a position, the less you are willing to think about it when you’re going in.
The Warren Buffet approach, he wants to buy something and hold it for a long time. He ideally wants to hold forever.
But the entire Wall Street charade is based on selling you something that as Frank Zappa said, “You shouldn’t or outn’t to buy.”
Build an Asset Allocation of low cost mutual funds and rebalance back to that allocation percentage once a year. How much liquidity do I need for that? Not much. If HFTs want to trade with each other, let them. If they create a big drop or big rise in the market take advantage of it.
February 24th, 2012 at 10:55 am
Here’s how Adam Smith might see it:
We have a town… it needs a mill and a lumber yard, some restaurants and shoe stores and all the rest.
Fortunately the town has some wealthy citizens and can build what it needs.
So one guy takes his money and invests in a new mill! A good idea! So he figures he will make a profit justified by the betterment it brings to the whole town. That’s what Mr. Smith had in mind more or less with his Capitalism idea.
But instead of the other wealthy citizens in the town investing in other things the people in the town need…
They place bets with each other on whether on not the mill will be successful.
Naturally since none of the other infrastructure was invested in… the mill fails. So does the town.
And half the bettors win. Though its a poorer world in which they’ll be spending their winnings.
Modern economics in a nutshell.
February 24th, 2012 at 10:59 am
… perhaps we need to ramp up our investment taxation (dividends and capital gains alike) to be paying a rate that is not only scaled by shear amount, but is also reduced by the length of time the investment has been held.
Something like a 50% tax on investments held for less than a minute, scaling up as the transaction amounts (aggregated by minutes, so that one cannot perform a million transactions inside a minute to slice up the transactions into smaller tax buckets) to something like 90% on amounts exceeding a million dollars.
Scale those rates downward, across the income spectrum, to something like 10% for investments (or dividends or interest collected on investments) that have been held for at least 5 years, in something like 5 “investment tax brackets”.
That would cure a HUGE amount of our investment problems. Pretty much overnight.
February 24th, 2012 at 11:09 am
It seems to me that liquidity has a direct relationship to volatility, but perhaps not an obvious one.
Markets that operate normally – and by this I mean during those periods which do not experience extreme events of say over 2 0r 3 standard deviations of volatility – have participants trading or investing with interests in a broad range of timeframes. These could include market makers and HFT interested primarily in almost instantaneous timeframes; the “trade” (fundamental) investors such as businesses in the trade itself (farmers, miners, central bankers) who take positions tied to intermediate time frames such as agricultural or business cycles (principally hedgers); buy and hold participants in it for the long term; and speculators who seek edges relative to all the timeframes between the other participants.
One can recognize positional advantages and disadvantages for each type of participant. Market makers have speed but don’t have choice about when to participate. The fundamental trade have more knowledge then any other types of participants, but have to participate relative specific time horizons.
Speculators have the great advantage of choosing when they play, but they have a disadvantage of being slower then the market makers and HFT and not having as much fundamental knowledge as the trade.
Normal or orderly markets will have investor interests across all time frames. This balances limit order books, has low volatility and all needed liquidity, and results in slowly climbing markets.
When time frame interests collapse toward a kind of singularity we see large imbalances in limit order books, evaporation of liquidity, and huge volatility.
HFT doesn’t alter the whole game, except that may have the advantage of exiting first when the time line collapses.
February 24th, 2012 at 11:12 am
It’s refreshing to see this. I’ve often felt that liquidity is one of those terms that sounds jargony enough that it’s trotted out to confuse people who might object to things on the grounds of common sense.
In my mind, when I hear someone justifying something because it provides “liquidity,” I immediately think “this guy has run out of arguments.”
Liquidity is like money (in some ways it is money): it’s terrible when you don’t have enough, but at a certain point, having more doesn’t solve your problems, and it can create new ones of its own.
February 24th, 2012 at 11:13 am
Investment counts for just 0.5% of Wall Street action…….
Makes those huge pension funds appear to be much riskier than they claim to be.
February 24th, 2012 at 12:25 pm
Thank you “Guest Author.” I think you hit the nail on the head.
All assets are liquid at the right price. In my opinion, banks and the FED love liquidity because they feel that it allows for more leverage. If you can dump those “toxic” assets on the turn of a dime, you can afford to lever up. As the author points out, liquid assets can become illiquid on the turn of a dime.
February 24th, 2012 at 12:39 pm
One more thing, I hate the argument that HFT “provides liquidity. Trading is a zero sum game, period. Every time HFT makes money, someone else is losing money, period. In this country where we encourage and incentivize people to invest their retirement savings into the stock market, do we really want them swimming with sharks?
Those who defend HFT can at least have the decency to provide an honest argument. There’s only one honest argument to defend HFT. “This is capitalism, if you can’t play in the man’s game, go home. We have the fastest computers, we have the best algorithms, we’re making money, your losing money, suck it.” I wouldn’t agree with that argument, but I could at least respect the person making it.
February 24th, 2012 at 1:17 pm
[...] John Bogle, “Liquidity is the last refuge of the scoundrel.” (Big Picture) [...]
February 24th, 2012 at 2:02 pm
Bill Wilson Says:
February 24th, 2012 at 12:39 pm
” One more thing, I hate the argument that HFT “provides liquidity. Trading is a zero sum game, period. Every time HFT makes money, someone else is losing money, period. ”
If I had a dime for every time I’ve made this exact same argument with an HFT proponent, who then concocts some convoluted rationale to dismiss my point, I’d be eating a lot of free lunches.
It’s just common sense, the money comes from somewhere.
February 24th, 2012 at 2:12 pm
Liquidity might be a worthy goal if people can demonstrate that there is a lack of it and that THEY will actually provide it when it’s needed, and NOT provide it when it is not needed. When the market is falling like a rock because everybody is scared to death, all these “liquidity providers” are hiding in the basement. When the market gets into a frenzy and really need to cool off, all these “liquidity providers” rush in and blow the bubble ever so much bigger. I say “off with their heads” (or at least lets get a financial transaction tax).
February 24th, 2012 at 2:39 pm
absolutely right on
i watched some smooth talking pinstriped scoundrel named Reynolds on Betty Liu Bloomberg this AM.
And thought please wont somebody confromt this liquidity BSer???
February 24th, 2012 at 4:19 pm
another complete scoundrel from today–they are everywhere
SEC Commissioner Paredes
US SEC’s Paredes calls for new Volcker rule draft–dow jones
Same BS
these SEC Commissioners should be given a media waterboarding
whenever they do something really inexcusable
like the Rakoff Appeal and this
February 24th, 2012 at 4:27 pm
he is a republican and certifiable wall st stooge. Froim Wiki
According to a 2008 Directorship report, “Paredes was a member of the corporate securities group at Irell & Manella, an associate in the corporate and energy and natural resources departments at Steptoe & Johnson, and worked in the corporate department at O’Melveny & Myers.” [6] A slightly earlier Wall Street Journal Law Blog article reports most of this information, adding that Paredes “focus[ed] on leveraged buyouts, mergers and acquisitions and other financings.” [5]
According to the WSJ and Directorship reports, “[i]n working papers in 2006 and 2007, Paredes took issue with a controversial SEC rule increasing oversight of hedge fund advisors….] The WSJ Law Blog went on to say that Paredes favored the SEC “recommend[ing] best practices and leav[ing] compliance up to the industry.”[5]
But the SEC commissioners Rakoff appeal was–i believe–unanimous
February 24th, 2012 at 4:36 pm
obama should be cleaning his own act up,
not supporting SEC nonaction the way he does
and campaign on
if you elect an R you will get more SEC commissioners and decisions like this joker
February 24th, 2012 at 4:45 pm
Paredes
So he went from calling for completely neutered SEC Commissioners
To being one
February 24th, 2012 at 4:55 pm
There is pretty clearly a media full court press on right now to dump the Volcker Rule…
February 24th, 2012 at 5:12 pm
To me the only liquidity that counts is the liquidity available the week that Lehman Brothers declares bankruptcy. If entities pull out of the market and refuse to provide “liquidity” at that moment, their previous history is then simply trading for their book instead of providing liquidity to the market.
The only major invention of liquidity in the past century that I can think of is FDIC/FSLIC insured bank accounts because that insurance means the general population doesn’t rush to the bank at the first sign of panic and pull all of their money out. If the banks themselves cannot provide liquidity at the moment, it is because the regulators allowed them to become far too over-leveraged which is what happened when Lehman declared bankruptcy.
February 24th, 2012 at 7:28 pm
The liquidity HFT provides is Yellow.
In every sense of the word.
February 24th, 2012 at 10:26 pm
I can’t help but think that the sporadic volatility is related to people with Blackberrys and other like devices who place stop orders. People that would otherwise review their positions nightly or weekly now do it hourly. And over the last 20 years many more people have figured out how to momentum trade. When too many people trade the same way it tends to stop working. Kind of like when everybody and their 401k, 403b, and IRA are in the market the markets don’t work so well. Because all those investors also vote for leaders who know their best chance of staying in power is if the stock markets go up! And interest rates stay low…..etc. Markets change……gh
February 25th, 2012 at 12:50 am
Joe and Sal, unconflicted, founders of electronic trading (almost, in a way that reminds me of Al Gore and the internet, but referencing Instinet always makes it seem like they understand the subject), making money by getting the “best” execution for your large order. But now, they just can’t seem to catch those fleeting orders, and the prices run away from their size. In the old days, they were better able to hide their intentions (nothing wrong with that, either). Nowadays, not so much. In the old days, the other side of the trade got splattered by J/S’s (legal) inside information that there was more to come. Nowadays, the other side gets a better price given what’s knowable because J/S’s data exhaust is better measured and the market, via HFT, knows a little bit more about actual value given the large size blowing through. Yes, large size, in every market since markets began, moves price, that’s why it’s critical to hide it if you want to move your large size without moving the price. Of course, that hammers the poor schmoes on the other side of the trade who are not privy to what the large size mover knows. Now some of that information is available to the schmoes, not by flash orders (no longer available), not by front running, but by doing EXACTLY what J/S used to do, reading the public tape, only better, with faster technology. Nope, no conflict here, except for the authors, who want to make their old margins at the expense of those with whom they trade. And not a thing wrong with that, if you can compete and beat the competition fair and square. Otherwise, you try to get BR to carry your water for you.
BTW, one of the ironies of the HFT witch hunt is that Bogle has been a vocal critic, but executives of Vanguard, which he founded, have gone public with the enormous increase in the value of a retirement account at maturity due to the incredibly reduced costs of trading over the life of the investment. Which, of course, are largely due to HFT and the leveling of the old playing field J/S miss.
February 25th, 2012 at 6:05 pm
There is a huge difference between liquidity and solvency. TARP made Wall Street liquid, it did not mke them solvent. That fact is being hidden through accounting control fraud and ignored by the Attorney General.
$Trillions have been stolen and MY / OUR GOVERNMENT could give a dam.
Steal from you – steal from me – give it all to the guy behind the government!!!!!!!!!!!!!!!!
February 26th, 2012 at 5:29 am
Perhaps the financial business and economists who feed on its jargon have been using the wrong metaphor to analyze the flow of funds through the capital markets. In light of the conversation surrounding the Volcker rule and Volcker’s observations on the question, perhaps a more suitable metaphor would focus on the digestive system, and view ‘capital’ as like ‘food and drink’ which are ‘digested’ through the markets in order to transform the intake into a new productive form. This seems to be a reasonably sound description of what healthy capital markets are purported to offer: a means of converting the surplus wealth of previous economic production into forms which will further increase, or maintain, productive capacity.
In this metaphor we would not be contrasting “frozen’ and “liquid’ markets, but states of “constipation” and “diarrhea”. Clearly a healthy capital market, like healthy bowels, will need to maintain a good balance between ‘regular movement’ of capital through the system and the need to avoid both ‘blockage’ and ‘dysentery’. Thus, the intervention of central banks or the activities of the ‘shadow banking system’ which manipulate the level of funding available to keep the process flowing could, at the extremes, be classified as various forms of bowel disease. Moreover, the various fraudulent schemes that chronically infest markets of all varieties could find their analogies in the various pathologies that infest digestive systems. If all of this feels a bit “icky”, and reminds one of the various noxious odors that accompany even ‘healthy’ bowel movements, that is evidence for the soundness of the metaphor too, since markets are inherently “messy” conduits for various goods that produce great benefits when operating in a healthy manner, and great calamities when they break down.
February 26th, 2012 at 9:17 pm
Volker and Bogle! Two giants, impeccable characters, great Americans, both hated by Wall Street of course. Imagine them running the Fed and the SEC with czar powers. They’re both in their eighties who’ll replace them?
BR: ready for the challenge? You wont make any money but you’ll do us all a lot of good. Just a thought.. Now, stop dreaming and here are some ideas:
1)Expose the ills of HTF from the bully pulpit (hello, POTUS anybody home?) and direct the SEC to stop HTF for say six months and watch if things get better; if so, ban HTF. The Europeans banned short selling for a period of time and the sky did not fall.
2) There will be protestations from all directions making a ban not feasible, thus,
3) Instead of imposing all kinds of taxing schemes (easily circumvented) require transaction records reporting so onerous, HTF would simply become impractical and a looser.
4) Commenting on the comments that HTF is a zero sum game: of course, EXCEPT for the friction losses (transaction costs, taxes, etc). Who is making the real money here? Those on the wrong side of the bets lose; those on the right side win but must pay taxes and fees. And the exchanges? win/win? after they cover their costs of course.
5) I remember the Enron executives lamenting that the fall of their company was due to a “run on the bank” situation, no liquidity….
6) If the HTF-ers migrate to other bourses, let them do damage there, I suspect they’d be eventually run off too.