How much “market liquidity”
is too much?
This is a difficult question to answer because you have unbounded it to be from an “Economic” point-
of-view. Economics is a dispassionate rubric that explicitly abstracts away real-world concerns. This
reduces its application to a real-world judgment such as the one you pose here. Additionally, I think
my answers to your headline question and the implicit question in the context are different.
Whether or not you can even conceive of too much liquidity in a market is sort of an existential
question. In general you want to have as much liquidity in any market you participate in so that you
can enter and exit investment positions at a certain point in time. However, highly liquid markets
should also be highly efficient markets which means that your ability to identify excess return in-
vestments may be restricted in very liquid markets. (Recent events clearly test this assumption.) So
economically, there are different benefits and trade-offs related to the volume of available liquidity.
For example, there was a lot of money to be made buying tracts of new growth forest and holding
it for decades to be monetized later. This is a very illiquid market, but potentially a lucrative and
socially valuable one.
What I think you are asking about, however, is the effect that HFT liquidity has on the market. A de-
fining characteristic of HFT is that it is not the same as general liquidity. For instance, in a downturn,
most momentum quantitative algorithms will actually contribute to the wrong side of the liquidity
equation by adding additional sales pressure. So, not only does it remove liquidity, it actually extends
the imbalance creating additional volatility. Further, it tends to react more quickly and severely than
fundamental investors are capable of, so HFT inflicts the losses to other market participants more
quickly and severely than if the strategies did not exist. This causes the market to amplify recency
effects and minimize long-term fundamental perspectives. From a societal value point-of-view, I
would say that this is detrimental. From an economics point-of-view, it doesn’t matter, it just is the
natural result of the structure of the system. Although some point out that economics addresses this
through its treatment of negative externalities, it’s still up to the viewer to have a perspective on what
is a negative externality.
So, in thinking about potential regulations on investment banks, I think there is a case to be made
against restricting momentum-based quantitative strategies that add to downward selling pressure
in severe market downturns, but this has to be weighed against, one, regulators’ ability to design
good policies that eliminate only the unwanted behaviors and effects and, two, the markets ability
to route around regulations. I’m sure most quantitative strategies would add enough fundamental
window dressing to claim that they are actually fundamental investors and should avoid restriction.
- Ranjit Kumar
What is the future of Financial Risk
Management?
Complexity of Analysis over complexity of models.
I would think that a move from complexity of models to complexity of analysis is overdue. Nicholas Nassim
Taleb makes this point in Anti-Fragile and labels it as the green lumber problem. In the simplest of terms the
most successful traders are traders whose analytical insights allows them to zero in on the real drivers in the
markets they trade. These traders are less informed; less educated than their more polished competition yet
are able to outperform the competition again and again. The green lumber label originates from the fact that
a trader who ate everyone’s lunch on the timber trading desk actually thought that green lumber was painted
green (green as in green or freshly cut wood versus seasoned or aged timber).
Reporting moves back to business
The other shift (I don’t see this happening immediately) is a shift of risk reporting lines back to business or trad-
ing desks. We moved risk to independent oversight a few decades ago and it’s been a disaster. The original driver
was conflict of interest and one of these days we will find a
better solutio
n than current reporting lines. The
current form doesn’t work because in most implementations it doesn’t have teeth (bite) and works off models
driven by an academic understanding of the real world. The best risk managers are former traders because they
understand model and mindset gaps between risk and trading desks.
-Jawwad Farid
What is your biggest Financial Planning
hurdle?
Taking that first step. For many people the fear of the unknown is far greater than the actual reality.
You need to go through a process to develop a financial plan. You cannot produce a sound financial plan with-
out going through a process of finding out where you are now.
Look at your assets and liabilities. How much do you spend at the moment and where? Generally people dislike
doing this for two reasons:
• Firstly, it is time consuming, to keep a detailed record. It requires commitment, you have to be thorough
and record everything.
• Secondly, when you analyze the results, it is like holding a mirror up to your life, often people find they are
existing rather than living.
It can be quite shocking. Many are fearful of what they will discover. But once the facts are laid out and you can
see exactly your situation, you begin feel better even if what you have discovered is not good.
Once you take that first step and face up to what, deep down inside, you know you really have to do, there is a
real sense of relief and achievement.
The process is the biggest financial planning hurdle. The most difficult and most painful.
- Jeremy Deedes
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