Friday, 17 March 2006

Market success, market failure

Liquidity is a coming theme in the financial markets. It is not the same thing as volume or turnover: having liquidity means you can sell something when you want to, not just in ordinary market conditions. There are signs that, despite rising volumes, liquidity (in this sense at least) is decreasing: Avinash Persaud uses the term `liquidity black holes' for those times when the market dries up and prices change dramatically without trading being possible. I think there is a good deal to be said for his thesis that these black holes are getting more frequent and more intense, but that will have to wait for another day: today I want to talk about the importance of liquidity in establishing a market.

In recent years we have seen several whole new markets appear: credit derivatives have transformed the trading of credit; weather derivatives have dramatically extended the trading of environmental risks; electricity derivatives are broadening the trading of power-related underlyings from the physical to the purely transferrable. Why do these new markets sometimes take off (credit derivatives being a good example) and sometimes fail to gather momentum (cat futures, despite the moderate successes of cat bonds, have never drawn much trading interest)?

One key is obviously liquidity, or at least the ability to hedge. The (single name) credit derivatives market started as an adjunct to the corporate credit market, and you could always hedge there. Moreover, most potential participants had risks that could roughly speaking be covered by buying a default swap. Weather trading has been slower because there is a lot of basis risk: you want to cover the risk of a low rainfall in Yorkshire because you are a water company; I am a Lancashire ice cream company who is willing to give up some of my excess profits if the summer in Manchester is hot. There's nearly a trade between us, but not quite: hot summers in Manchester do not necessarily mean low rainfall over Leeds and vice versa. Hence we both end up paying an intermediary, an investment bank perhaps, to run that basis risk. The bank charges both of us and the market has less liquidity.

The thing that brought this theme to mind was the nascent market in property derivatives in the UK. This has all the ingredients for success: a good underlying (the investment property database, which covers over three quarters of commerical property); an attractive asset class; high costs for trading directly in the underlying (roughly a 7% bid/offer spread); and a reasonable regulatory framework (now property derivatives are admissable assets for insurers). It is not perhaps quite the Kaiser Chiefs (I predict a riot), but certainly considerable growth can be expected.

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