The focus for our classes on September 26 and 27 was the theme of “Financial Innovations in Markets.” At this point, we shifted our attention from the drivers of innovation, to its manifestations—we started looking at innovations in markets, institutions, services, instruments, and innovations for social impact. The purpose of looking at financial innovations in these various forms is to develop a critical point of view.
What do financial markets do for us? Any critical point of view has to begin with an understanding of ideal function and goals for markets. Such understanding is the focus of the field of market microstructure within financial economics. In his chapter on the NYSE, Richard Sylla argued that financial markets serve several needs: they pool resources; subdivide claims for investor convenience; mobilize capital by channeling funds from savers to users; allocate capital efficiently; afford ways of managing risk and create useful economic information. To these I would add that they afford liquidity to investors and, to the extent that markets are organized in some way, they tend to promote orderliness.
Imagine a world with no markets: we would have to search for products and buy them through some barter-like negotiation. Shopping for the bare essentials would be enormously costly in time and money. The modern American supermarket or big box retailer gathers thousands of stocking units under one roof and offers these goods at take-it-or-leave-it prices. In communities large enough for two or more competitors, the prices are likely to be competitive. The upshot is that the existence of these markets might lower our costs of search and transaction.
We have seen examples of the benefits of financial markets this week and in prior weeks:
· The advent of trading in options and futures contracts in Amsterdam between 1550 and 1650. As trade in spices and other commodities from the Dutch East Indies boomed, merchants needed to limit their exposure to price fluctuations. Initially the instruments traded were bespoke designs. As trading expanded, the instruments became more standardized.
· The advent of new markets in kidneys and marriage partners. In the absence of such markets, finding a counterparty is hit-or-miss, and consequences of failure are disastrous. Innovative markets have been created that use search algorithms to match up counterparties.
· Electronic trading of securities on new exchanges has dramatically lowered execution costs and possibly increased liquidity.
· As described in Michael Lewis’s book, Flash Boys, which we discussed earlier in the course, Brad Katsuyama’s new IEX market offers an alternative to exploitative front-running in “dark pool” markets.
· Flip Pidot (D’02) visited our class and discussed his efforts to launch American Civics Exchange (ACE), which would enable investors to trade instruments whose value derived from outcomes of elections, legislative votes, and regulatory actions. With Flip’s assistance, we explored PredictIt.org, a prediction market; and we considered the change in polling percentages following a major presidential debate. ACE and PredictIt could enable a participant to hedge risks that might stem from civic events or government actions.
Markets manufacture information. Prices are the most important kind of information that markets produce. Markets also provide useful information about liquidity, volatility, risk, and correlation. Investors use this information to trade in the market as well as for decisions outside the market. For instance, corporations use “beta” (a measure of the volatility of a firm’s stock price relative to the volatility of the stock market) in estimating the return that stockholders require from the company. The cost of equity, combined with the cost of debt (informed by interest rates) determines the cost of capital for a company. The market-based cost of capital is used in making a host of important corporate decisions about capital investments, acquisitions, restructurings, stock buybacks, and so on.
Markets also can provide information about market participants. The spreads of an issuer’s debt relative to risk-free bonds is an indication of the risk of that issuer. The inability of some financial institutions to borrow in the repo funds market during the Panic of 2008 was evidence that investors doubted the creditworthiness of those institutions.
The market as a search engine. Markets bring buyers and sellers together. Markets lower the cost of finding a counterparty to do a trade. This search-related benefit of markets is sometimes referred to as liquidity. Larry Harris, former Chief Economist of the SEC, wrote, “Liquidity is the ability to trade large size quickly, at low cost, when you want to trade. It is the most important characteristic of well-functioning markets.” ((Larry Harris, Trading and Exchanges, 2003, Oxford University Press, page 394.)) Market makers, dealers, and brokers help to promote liquidity. As the articles about the NYSE in 1792 and 1914 suggest, the absence of liquidity in one market can stimulate financial entrepreneurs to establish a new market.
The benefits of a market depend on trading volume. Growth in the number of trading participants tends to improve market efficiency. With few participants, the views and behavior of any one participant will have an outsized effect on prices and trading volume. Recall from our discussion in week 4 that market efficiency means that prices reflect relevant information about the asset underlying the financial instrument. More market participants bring more diversity of opinion and more channels by which information can enter market prices. An increase in the number of market participants increases the likelihood that prices will be efficient. Higher trading volume helps price discovery.
Of course, what matters is not just any kind of trading. Uninformed day-traders simply add noise to the market prices. The kind of traders who really help price discovery are informed traders—these tend to drive security prices toward their intrinsic values. Informed traders reflect many styles: value traders estimate intrinsic values of securities from all the fundamental information they can find; news traders act on new information; technical traders respond to predictable price patterns caused by noise traders, shifts in market sentiment, or statistical aberrations (technical traders tend to rely on algorithmic trading models); and arbitrageurs simultaneously buy and sell similar instruments to exploit pricing anomalies. More of this informed trading helps price discovery.
We considered examples of new markets that failed because of insufficient trading volume. The case of Robert Shiller’s MacroMarkets house price derivatives showed that low trading volume during the panic of 2008-2009 doomed the attempt to launch the new instruments. In his conversation with us, Shiller remained confident that a market in these instruments would arise eventually. Also during this week, we discussed the Chicago Climate Exchange, which ceased its trading of carbon emissions in 2010 due to inactivity in trading for trading greenhouse gas emission allowances. Though these instruments make sense as a device for adding the cost of pollution to the pricing of goods and services, the absence of a government mandate made the participation in this market voluntary for companies. Trading volume remained insufficient and the market closed.
In class, we conducted an exercise about locating the market for trading in sukuk (sharia compliant) bonds. We considered London for its large and liquid markets, its desirable legal system, and its familiarity with Islamic finance. Another candidate was Dubai, which was attractive for its ease of doing business and competitiveness as a business center. The third candidate was Kuala Lumpur, Malaysia—the sukuk market settled in KL. Malaysia is the largest sukuk issuer in the world, accounting for about 70% of total issuances. And Malaysia requires that all debt issuances be rated. And there is a big local demand for sukuk issues in Malaysia. It seems that prospective trading volume attracted the sukuk bond market to KL.
Market disorder tends to lead to government intervention and rules. We discussed the origins of the New York Stock Exchange. Following financial panics in 1791 and 1792, the New York State legislature banned open-air auctions of securities. It was thought that simply closing the financial market permanently would prevent future panics. But dealers and investors and therefore gathered under a buttonwood tree in lower Manhattan to form a club that would facilitate trading, but only among members. Membership in the club would be limited by certain entry criteria, and trading would occur on the basis of certain rules. This is an early example of regulatory arbitrage, discussed in my liveblog post for Week 5.
Another case of disorder and invention occurred in 1914. We discussed the impact on market liquidity when the U.S. government closed the NYSE. The government was afraid that Europeans would sell American financial securities at the outbreak of World War I and attempt to repatriate stocks of gold to their own countries. A massive and sudden outflow of gold could destabilize the U.S. financial system. Thus, the government simply closed the market. But traders formed an informal securities market “on the curb” of the NYSE. The article by William Silber found that securities prices in this alternative market remained relatively competitive and efficient. Regulatory arbitrage struck again.
We also looked at an example of a benign influence of government: the advent of the 30-year amortizing mortgage. The article by Rose and Snowden described the impact of the Great Depression on mortgage lending. Before the Depression, house purchases were financed with interest-only balloon payment contracts. The maturity of such loans during the depression when unemployment was high figured in the bankruptcy of many consumers. The amortizing mortgage loan reduced the risk associated with longer terms. The Federal Housing Administration, Federal Savings and Loan Insurance Corporation, and Home Owners Loan Corporation used their powers to motivate banks and S&Ls to adopt the amortizing mortgage model.
Another example of government stimulation for innovation in financial markets was discussed in the article by Gerardi, Rosen, and Willen. They found that federal deregulation of the mortgage market and of the S&L industry in the mid-1980s led to increased integration between real estate finance and other financial markets. The mortgage securitization market boomed. Consumers enjoyed greater tailoring in the design of mortgages. And credit constraints relaxed, particularly for borrowers at the low end of the house value distribution.
Questions for innovators in new financial markets:
1. What is the problem that this new market solves? What is being priced? To whom is the pricing information useful? In his chapter on “Market Designers and Financial Engineers,” Robert Shiller wrote, “Market designers, sometimes called mechanism designers, start with a problem—the need for a market solution to some real human quandary—and then design a market and associated contracts to solve the problem.” ((Robert Shiller, Finance and the Good Society, page 69.)) Consistent with our studies over the preceding five weeks, consider how profit, risk, market incompleteness, market inefficiency, and government action might contribute to the case for this new market. Another way to answer these questions is to consider the list of functions that markets perform: they pool resources; subdivide claims for investor convenience; mobilize capital by channeling funds from savers to users; allocate capital efficiently; afford ways of managing risk; create useful economic information; afford liquidity to investors and, promote orderliness—to whom are these benefits valuable, and why?
2. Can this new market gain reasonable trading volume and liquidity? Can it attract informed traders? Markets are search engines. For a search engine to be effective, it needs plenty of counterparties. Try to identify a demand for services from the market. How large and stable is the demand?
3. Who rules, and how? Obtaining a license to operate from most national governments typically requires sharp clarity about the new market’s governance and operations. Norms and rules of operation will be necessary for orderly functioning. These might address who can trade (are there conditions for entry into the market?), how trades are settled (by cash or credit? Over what time period?), disclosure of trading and the condition of traders (do they have the financial capacity to settle their trades?), and enforcement of infractions of rules (by whom? When?)
4. Why now? The economic context has an immense influence on the eventual success or failure of the new market. MacroMarkets introduced its new derivatives on house prices shortly after the Panic of 2008, when house prices had been battered down, and found few takers for its insurance. Markets for greenhouse gas emission allowances have depended on government mandates and incentives to promote such trading. Regulations generally have been known to stimulate innovations to arbitrage around the regulatory constraints. And technological innovations can stimulate financial innovations, as evident in the rise of high frequency trading exchanges and the blockchain.
5. Who or what is being displaced by the creation of this new market? Incumbents can be tenacious competitors. The algorithm-based market for kidneys displaced informal networks of unilateral search. Match.com displaces informal social networks, bars, and professional matchmakers. “Dark pools” displaced slower and more transparent markets. ACE and the Amsterdam options and futures exchanges displace self-insurance.