Understanding Finance #3: What kind of financial markets do we need?
According to the textbooks, financial markets should be a vehicle through which capital can be allocated to projects that are economically useful (and ideally socially useful and environmentally sustainable too), to the benefit of society. As such, they should play an essential role in our economy. They also happen to be deeply woven into our lives as consumers, as means to manage our savings, pensions and insurance.
In this multimedia dossier you can learn what financial markets are for and how they have developed in recent decades. In the second part, we look at some of the lobby myths told about financial markets and explain why Finance Watch thinks they are mistaken.
- What are financial markets and what are they for?
- What functions are financial markets supposed to fulfil?
- Historical perspective: How investing became betting
- How much liquidity do we really need?
Put simply, a financial market is a place where assets (such as equities, bonds, currencies, derivatives...) are bought and sold by different actors, according to market rules. The market allows for prices to be set for the risks and rewards of investing. There are several ways to be involved:
1. The issuer (company, government...) taps the market in search of funding. She sells securities, such as shares in a company ("equity") or debt in the form of bonds, and looks for stable, long-term investors to buy them. The issuer gets to use the funding and undertakes to pay her investors a return, such as a dividend on a share or interest on a bond.
2. The investor (individual, pension or investment fund, government, company...) wants to put capital to work. He will look for a return that he thinks provides a fair remuneration for his exposure to risks, such as the risk that the issuer gets into financial difficulties, or the risk that the security cannot be sold in the secondary market for any reason. Fund managers and other institutional investors act on behalf of the millions of ordinary people saving for their pensions, who are the real end investors.
3. The chain of intermediaries (banks, brokers, market makers, fund managers...) connects investors at one end to issuers at the other. Intermediaries help the markets to run more smoothly, although they add to investors' transaction costs. Other things being equal, more intermediation means lower returns for the end investor.
A Simple Financial Intermediation Framework
On the right side of the figure, we have ultimate creditors (called also ultimate savers). This group includes households with their savings and investors willing to buy assets (e.g. corporations, pension funds etc.). On the left hand side, we have ultimate borrowers (e.g. corporations and financial institutions issuing bonds or shares, households taking loans etc.). The financial sector includes everything that happens in-between and where financial intermediaries (banks, brokers, market makers, fund managers...) play a key role. For example, household savings can be channelled through traditional banks to investments or loans, or through financial markets to equities, bonds and other investments.
"Simplified view of financial intermediation" (source: IMF, reproduced by Finance Watch)
A well-functioning infrastructure is not enough to guarantee that financial markets are effective. The conduct of market participants also determines the value that financial markets bring to the real economy and society. That requires rules written by policymakers and regulators, and supervisors who enforce them, as well as codes of conduct and ethical commitments by market participants themselves.
This video is a good introduction to financial markets, made by Tim Bennett from Money Week.
The primary objective of financial markets is to channel savings and capital to the most productive activities in the economy.
In more detail, financial markets fulfil three basic economic functions related to the real economy:
- Channel savings, investments and allocate capital: Primary markets are where financial assets (shares, bonds, derivatives) are initially created and distributed. This is where new capital formation takes place, when companies and governments sell newly issued shares or bonds to investors in the market. In the case of shares, companies ‘float’ their shares on the stock exchange for the first time through an IPO (Initial Public Offering), and can make follow-on offerings or rights issues to sell more shares in the future (see this video with Paddy Hirsch explaining what IPOs are). The buyers are largely institutional investors, such as investment funds.
- Trading of existing assets and price formation: Investors must be able to exit their investment if they want to. That is why once the initial securities are sold in the primary market, they can be traded in the secondary market. Secondary markets are much bigger than primary markets. Economically, they do not bring any fresh capital but they do allow investors to trade existing securities between themselves, to enter and exit the market, and to set prices for the securities being traded. These all help the primary market to function, among other things.
In theory, prices should reflect the fundamental value of securities and fluctuate in line with the fortunes of the issuer (micro-economics, or endogenous factors) and the general economy (macro-economics, or exogenous factors). It is these price signals that help to direct capital to productive use, for example by encouraging investment in companies that are doing well, and vice versa. In reality, secondary markets can become a speculator’s heaven and prices are sometimes a long way from fundamental value and prone to bubbles and crashes. An abundant literature has grown up on this topic (see for example, the work of the Paul Woolley Centre for the Study of Capital Market Dysfunction at the London School of Economics).
- Risk management: The third function of financial markets is to help manage risks that arise in the real and financial parts of the economy. For example, a construction company may want to hedge against rising steel prices, or a pension fund may want to hedge against falling interest rates. Specific instruments (mainly derivatives) allow market participants to transfer their various risks (credit risk, interest rate risk, etc.) to other market participants who are more willing to take that risk. This can allow businesses to engage in activities they would not otherwise have done.
Of course, transferring risk does not eliminate it, as the financial crisis showed rather dramatically. In addition, the fact that many derivatives can be issued and traded in greater quantities that the underlying risks or assets they relate to makes them ideal tools for speculation. This helps to explain why, especially in recent years, there have come to be far more derivatives in issue than there are underlying assets: the notional amount of outstanding derivatives is around nine times the size of the entire world’s GDP, or roughly USD 100,000 for every man, woman and child alive on the planet.
Vanguard Group founder John Bogle explains why he thinks today's financial markets mainly benefit rent-seeking intermediaries:
"The job of finance is to provide capital to companies. We do it to the tune of $250 billion a year in IPOs and secondary offerings. What else do we do? We encourage investors to trade about $32 trillion a year. So the way I calculate it, 99% of what we do in this industry is people trading with one another, with a gain only to the middleman. It's a waste of resources." (Interview with MarketWatch, 1 August 2015)
In order to perform the above-mentioned functions effectively, financial markets must be:
- Fair: equally accessible to all market participants, protected from abusive behaviour.
- Orderly: supply and demand for assets are roughly equal, and volatility is low.
- Transparent: there is public information about offers to buy or sell (‘pre-trade’) and transactions executed (‘post-trade’), including volume and price.
- Secure: market structures and processes must secure transactions at each step of the chain: trading, clearing and settlement.
Traditionally, financial markets were closely linked to the real economy, whose activities they financed. Since the mid-1990s though, this link is fading away. Deregulation of the equity, bond and derivatives markets has seen more and more capital directed towards short-term, speculative uses.
A) Wrong incentives
Investment and speculation are not just differentiated by time horizon. On the basis of transparent information in fair markets, investment creates a partnership between the corporation or entity being financed and the investor – linking them together in success or adversity. The value captured by the investor derives from real economy activity. The investor and the entity being funded are winning or losing together. Speculation, on the other hand, is a zero sum game where the money earned by a speculator is lost by the other side of the transaction and vice-versa. As we understand speculation to be the extraction of profit from the buying and selling of assets, it relies on highly liquid secondary markets. Speculation, however, is no longer a zero sum game when it affects other parties, or creates what economists call “negative economic externalities” that fall on society at large.
This is a short Finance Watch animation to explain the link between speculation in agricultural commodity derivatives and the behaviour of prices (energy, food, etc).
As Keynes argued, markets could only be efficient in allocating capital to the most productive uses if the vast majority of market participants have what he calls an ‘enterprise’ perspective (which we will call ‘investment’), as opposed to a ‘speculative’ perspective. In drawing lessons from the 1929 crisis caused by a financial bubble, Keynes does not blame greedy, ill-intentioned individuals. He is rather pointing to a market structure that incentivises speculative behaviour over the sound allocation of capital. Financial markets need to be ‘helped’ to fulfil their core functions to the real economy. Without such a framework, the next crisis caused by a financial bubble is only around the corner.
B) Interconnectedness of the financial system
In theory, a financial bubble does not necessarily affect actors outside the bubble, but it can if insurance companies, pension funds, commercial banks and investment banks are all involved and intertwined in the bubble. And, the less transparency and information there is about financial products, the more likely it is that toxic products will be sold throughout the whole financial system. But even non-toxic investments contribute to the interconnectedness of the financial system, because price movements and investment decisions affect many different actors at the same time. Imagine that many banks made similar investments and the riskiness of those assets changed, then the banks would all be affected at the same time, potentially causing a series of banks to default.
Another factor contributing to the interconnectedness of the financial institutions is that much bank funding comes not only from deposits, but also from other banks, pension funds, asset managers, hedge funds etc. This so-called “wholesale” funding has fuelled the growth in banks’ trading activity. And it was artificially cheap, as investors assume that banks with insured deposits and a trading operation capable of dragging down other banks will not be allowed to fail. This creates a problem for bank regulators: in a crisis, regulators will not be able to impose losses on large banks’ creditors (a process known as “bail-in”) for fear of passing on risk to other parts of the financial system. If you want to know more about it, you can read our publication "Europe’s banking trilemma".
C) Oversized banks
The rapid growth of megabanks was another factor in the financial crisis. As described by James Rickards, “Borrowers were reckless, brokers were greedy, rating agencies were negligent, customers were naïve, and government encouraged the fiasco with unrealistic housing goals and unlimited lines of credit at Fannie Mae and Freddie Mac. Yet, the fact that there were so many parties to blame should not be used to deflect blame from the most responsible parties of all—the big banks. Without the banks providing financing to the mortgage brokers and Wall Street while underwriting their own issues of toxic securities, the entire pyramid scheme would never have got off the ground”.
That is another reason why Finance Watch calls for a new separation of banking activities (if you want to know more, please have a look at our first multimedia dossier “Understanding Finance #1: Splitting megabanks?”).
Can we keep up with financial markets? TED talk on writing things we can no longer read
Alan Greenspan, chairman of the US Federal Reserve bank from 1987 to 2006, described the difficulty of controlling modern financial markets in his 2007 book, the Age of Turbulences: “Markets have become too huge, complex, and fast-moving to be subject to twentieth-century supervision and regulation. Regulators can still pretend to provide oversight, but their capabilities are much diminished and declining.”
The lack of strong financial regulation has led to financial markets starting to write things (such as high frequency trading, see below) we can no longer read. Kevin Slavin gave a brilliant TED talk on this topic.
In financial markets, liquidity is a key concept. From the investors’ perspective, liquidity can be described as the ability to convert an asset in their portfolio into cash or another asset in a reasonable time frame, without being penalised by price movements.
From the speculators’ perspective, liquidity is seen as the ability to buy and sell assets of any kind as often as desired to exploit price movements. If market activity is mainly speculative, liquidity might rapidly dry up with everyone running to buy/sell at the same time.
Markets that rely too much on short-term liquidity are therefore vulnerable to ‘drying up’, as the interbank lending market did in 2008. In addition, investors who focus too much on liquidity, for example only buying assets that they can easily sell if the market price falls, may be less interested in studying the underlying risks of an asset, its nature and even less its social and environmental objectives before buying it.
According to Keynes, the doctrine of liquidity distracts investors from their social object of allocating capital for productive use. He said that none of the maxims of orthodox finance was “more anti-social than the fetish of liquidity” (for more on this topic, see our blog “Liquidity – a double-edged sword”).
High-frequency trading (HFT)
The rise of high frequency trading (HFT) is another example of new techniques and strategies that can threaten market fairness, order and integrity. HFT is the use of algorithms and computers to execute ultra-fast trading strategies and has come to dominate trading in many financial markets. Institutional investors use algorithms to disguise large trades, while specialist HFT firms use their algorithms to find and exploit those trades. HFT strategies can damage investors’ trust in markets, drain useful liquidity and increase the potential for market abuse (see Debunking Myths in Part 2).
Have a look at our infographic on High-Frequency Trading!
The financial industry lobbies hard – and with some success – to weaken legislative initiatives that might affect their interests. This has given rise to a number of myths, some of which are promoted to scare politicians into relaxing financial market rules. Here are Finance Watch’s responses to a few of them.
Financial industry lobby: “Markets are efficient by nature - Any external intervention should be restricted to the minimum”
This myth follows the Efficient Markets Hypothesis (EMH). This theory assumes that market participants are ‘rational maximisers’ and that the allocation of capital will be optimal because the price formation mechanism is perfect and actors are perfectly rational. In that perspective, any external intervention (governments, regulators) has a direct negative impact on markets’ ability to serve their purpose. Hence the strong stance that derives from the EMH in favour of ‘self-regulation’.
It is fair to say that belief in the efficiency of markets has dominated market regulation over the past 30 years. Legislative initiatives have systematically promoted competition via the creation of a ‘level-playing field’, based on the principle that competing private interests would result in more effectiveness, serving the public good.
However, as many realised during the financial crises, there is a tendency for market participants to focus on extracting the maximum short-term profit based on asset prices rather than developing a longer-term investment strategy based on future returns from the underlying asset. Market participants do not act naturally as pure ‘rational maximisers’ searching for a price that reflects fundamental value. On the contrary, as is well known to all market professionals, market participants are also influenced by irrational human behaviours (fear, greed, herd instinct etc.) and very few can resist the temptation to profit from a price change even if that price does not reflect the fundamental value of the security being traded.
Market data suggest that the financial sector has become less efficient in recent years. Research into the unit cost of financial intermediation (roughly, the value of all financial assets divided by the GDP share of the financial sector) shows that it is now more expensive to support a euro of financial assets than it was in the 1990s, not less. This is despite the innovations and proclaimed efficiencies of market-based financing that have emerged since then.
Financial industry lobby: “High-frequency trading increases market liquidity”
HFT creates volume but not liquidity. It is either built on trend-following strategies that generate volume but take away liquidity, as evidenced by their market impact, or on so-called ‘liquidity-making’ strategies that collect liquidity rebates (small payments that stock exchanges give in return for order flow). In reality, this strategy provides no liquidity because the limited depth and millliseconds’ duration of their quotes denies proper investors the chance to transact for significant amounts when needed. HFT actually withdraws liquidity from the market as it competes with genuine investors each time those investors want to execute a transaction in a context where HFT’s so-called passive quotes have usually evaporated by the time a genuine investor tries to transact with them. HFT threatens market fairness, order and integrity. For more critical commentaries on HFT, see (among others) the Zero Hedge blog.
Financial industry lobby: “Financialisation always brings economic growth”
Financial deepening in the world’s advanced economies has increased dramatically, especially since the financial deregulation epoch began in the 1980s. However, has this financialisation of the economy always been good for growth? The IMF said recently: “Our analysis uncovers evidence of ‘too much finance’ in the sense that beyond a certain level of financial development, the positive effect on economic growth begins to decline, while costs in terms of economic and financial volatility begin to rise”. At high levels of private credit to GDP (“financial deepening”), more finance is associated with less growth, something that researchers at the IMF refer to as the “vanishing effect of financial depth”.
Extract from Finance Watch cartoon on “Basel 3: return of the Regulator”
However, while an overdeveloped financial sector is, in general, a burden on the economy, specific types of credit are linked with growth. Bank lending to businesses outside the financial sector is positively linked with economic growth. It is more productive, for example, than bank lending to financial businesses or real estate. The problem is that the largest EU banks are today focussed mainly on non-lending activities, such as trading and making markets in financial assets, or on lending to less productive activities such as real estate.
In November 2014, Finance Watch organised the event "What finance for what growth?” We published the transcript of the conference and a factsheet.
The current wave of (re-)regulation in the US and EU should be based on a realistic understanding of how market participants make decisions and under which conditions they make those decisions. The last 30 years – and the most recent half of that period in particular – showed us that self-regulation in the markets for equities, bonds and derivatives did not always bring financial stability and benefits to society.
A system of self-regulated markets designed to promote competition resulted instead in the concentration of market power in a few hands, the rise of complex ‘ad hoc’ market structures and deregulation. Regulators must address these features if they are to restore stability and fairness to financial markets, remembering always that markets should adapt to regulations, not the other way around. Without proper regulation, bad practices can spread easily, as the subprime crisis demonstrated.
Policy makers rightly wish, in a period of economic underperformance, to re-direct capital from short-term and often speculative strategies to long-term investment in the economy. For those who have benefited from short-term strategies this shift is going to hurt. There is no point denying this. But over time, this reality will allow business models to adapt and be renewed for the benefit of all. In that respect, we must keep in mind the market’s primary purpose of capital allocation and remember that the costs of financial intermediation are only ever justified if they serve the needs of the economy and of society at large. Finance Watch is of the view that policy makers should seriously question the usefulness of financial activities that are not customer facing or that do not contribute to bringing capital to productive use. If you want to dig deeper into these topics, have a look at our position paper on the EU financial markets regulation (MiFID II) entitled “Investing, not betting”.
A shift from short-term ‘betting’ strategies towards longer-term investment would transform the financial system into one that serves the real economy and society as a whole. Unfortunately the Capital Markets Union, a new EU-initiative, risks promoting short term growth over long-term investment. If you want to know more refer to our recently published position paper and cartoon.