Could a ‘Bond Market Liquidity’ Crisis be a Good Thing?

I have long held the view that investors trade too much. Capital markets’ raison d’etre are to provide an avenue for today’s savers to consume in the future. Savers receive a rate of return as a reward. How much trading is required to support this basic activity?

Consider this simple math. If investment returns are, say, 5% per year then savers can consume 5% without depleting their capital. Simplistically, this suggests that savers need to sell about 5% of their portfolio each year to feed themselves and still be able to feed themselves indefinitely into the future.  One would expect, therefore, that annual turnover in the capital markets should be close to 5% since this is what gets consumed. Right?

Wrong … a quick Google search reveals astonishing turnover rates in both stocks and bonds.  The World Bank, for instance, reported that turnover in the US Stock Market was 182% in 2012 while the Bank of Canada reports that turnover in the US Treasury market is over 19 times the quantity of US Treasuries on issue!

The simple math I outlined above does not take account of the important roles of price discovery, risk shifting and risk diversification that the capital markets perform. But honestly, can these additional trading motivations turn a 5% consumption need into182% turnover in stocks let alone 1900% in US Treasuries? Trading, of course, comes with a transactions cost which supports the financial sector and must be recouped by investors as an higher return to justify the investment in the first place.

Which leads me to the question of whether there is  crisis looming in the bond markets due to lack of liquidity. What aspect of market efficiency requires the US Treasury market to turnover 19 times each year? And who is doing all this trading?

A ‘liquidity crisis’ to my thinking is when bona-fide savers cannot access their wealth to finance their consumption needs.  Shutting banks, rationing credit and freezing or sequesting assets qualify for this label.  There is no suggestion, however, that banks’ shutting their proprietary trading desks or voluntarilty withdrawing capital from traditional market making activities, is in any way impeding Mr and Mrs Wong/Smith/Watanabe from withdrawing their meagre interest on their savings to feed themselves and their cat.

The exit door may well get crowded for leveraged high frequency trading operations, but the economic cost of impeding these operations depends critically on this sector’s contribution to market efficiency in the first place. I conjecture that the macro-benefits delivered from HFT is ‘not much’. In fact, there is a largely unrecognized corner of the academic literature which argues that lowering turnover to levels consistent with the basic saving/consumption model of investment will lead to permanently higher asset prices(1).  This might be a good thing.



(1) See Fisher (1994) Asset trading, transaction costs and the equity premium Journal of Applied Econometrics