On transaction liquidity

Naked Capitalism has a typically engaging post on transaction liquidity.

One of the arguments apparently being made in Washington by those who oppose regulation of credit default swaps is that it would reduce liquidity and that of course would be a terrible thing.

Fair enough. A priori it is not clear if having transaction liquidity is a good or a bad thing.

One of the comments I have heard from debt market participants in the bubble era was that they were faced with a 'wall of liquidity", tons of money looking for places to park it. And some of that appeared to be the direct result of credit default swaps. CDS allowed banks in Europe to circumvent capital requirements, enabled investment banks to accelerate profits from deals into the current period by (in theory) defeasing risk, allowed banks to extend bigger loans than they would have otherwise by hedging some of the risk.

Let us look at these one by one.

• Capital. That was the regulator's fault and not the banks'. And it had little to do with liquidity. So yes, it was a bad thing, but it has nothing to do with either CDS per se or with transaction liquidity.
  
• Profits. There are arguments in both directions for fair value vs. accrual, but again this has nothing to do with either CDS or liquidity.
  
• Hedging. Here's the nub. A lower cost of capital is good for the economy when it is growing. But if it is created by over-leveraging the financial system, then clearly it is dangerous.

Let us turn back to NC:

Behavioral finance studies have found that even in simple bidding setting, participants create bubbles. Low transaction costs and the appearance of abundant liquidity supports short-term, momentum based trading strategies, with participants believing they can find the exits when they need to... Higher frictional costs lead investors to think twice about adding and exiting positions.

This is also a good point. Transaction liquidity supports the development of crowded trades, but often there is not enough to support their closing. I wonder if we should consider some form of frequency based regulation, whereby more frequent traders require more capital.

Personally, then, I think the case remains tantalisingly unproven. In traditional equity markets, abundant liquidity supports price discovery, permits speedy asset reallocation, and lowers everyone's cost of capital. But patchy liquidity, whereby there are periods of liquidity which can suddenly disappear, as in the ABS market and some other areas of credit, is deeply unhelpful. What we really need is more constant liquidity, so that liquidity assessment is possible for the life of a trade. Perhaps market maker requirements have a place here: obliging firms to provide liquidity in good times and bad - a feature of the equity but the credit markets - could help to even things out. And certainly if we are going to intervene to improve liquidity (as in the TALF), then we need to consider the possible negative effects of too much liquidity.