As the Volcker Plan limps through Washington and many are screaming bloody Armageddon, an idea has been floating through my head. This is an idea that is sure to really rile up those on Wall Street, many readers of this blog, and followers on Twitter. It is an idea that at the onset seems ridiculous but after pondering for some time has some merit. This idea is nationalizing market-making in vanilla financial instruments.
Liquidity is to the flow of capital as as roads are to the flow of traffic. Most would argue that both the flow of capital and the flow of traffic are both vital to economic well-being. Yet unlike in transportation, in markets we largely leave our market infrastructure up to the private sector. While provision of transportation infrastructure would not pass the public policy test of a pure public good, many would agree that is important and government has a inherent interest in making sure that traffic flows. Why not leave this role up to the government in the capital markets?
Below are some reasons why this idea keeps banging through my head:
Additional Tools for Policy Makers
Over the past 20 years we have experience multiple liquidity crises where the Fed has had to step in and provide liquidity to financial institutions so that they could turn around and use that money to get the markets moving again – aka make markets. The government is already somewhat on the hook as a “liquidity provider of last resort” to the markets, so why not do it all the time.
Think about the additional tools it would give policy makers. Markets getting bubbly? Increase your spreads. Capital not moving? Decreae your spreads. Too much debt being issued? Shift market making capital to equities. Want to create the incentive for Alternative Energy companies? Make liquid markets in their debt and equity. The private sector would never do this. They make markets in wherever it is most profitable at the time. Sometimes to aid other businesses that they are in and can get out of the game in a moments notice.
A housing boom, any kind of boom, is attended by an increase in certainty. Information is stimulus, confusion is contraction. A bust occurs when the market is unsure of everything, when market participants perceive better risk-adjusted return in holding government securities (or supply-inelastic commodities) than in financing real investment. Sectoral shifts per se have no clear implication with respect to variables like employment and output. But “hangovers” do happen, because powerful booms are periods when market participants make consequential decisions with great swagger and confidence, and busts are when we learn that despite their certainty, they were wrong. They are left not only impoverished and burdened by debt, but bereft of confidence in their ability to evaluate new opportunities. The best way to avoid the hangover is not to err so terribly in the first place. Easier said than done, perhaps, but that’s no reason to cop out. We can build a better financial system, one in which degrees of certainty are attached and removed from economic propositions dexterously, rather than clinging like giddy leeches until a collapse.
Nationalizing market making gives policy makers a really interesting way to receive information from and inject information into the markets. I take Waldman’s premise further and say that Capital flows towards information. Under a lens of uncertainty, capital doesn’t flow, but if capital knows that there is a liquidity provider out there with an interest in allowing it to flow, it can flow more smoothly. Nowhere can this seen better than the capital flow to arbitrage strategies, the “sure” thing.
Ability to Put Financial Innovation to Good Use
The last decade of financial innovation in the form of financial engineering should be used to improve market microstructure not allow a few rich people to profit. Staying with the transportation metaphor, engineering breakthroughs such as bridges and roads weren’t built for a few rich people to benefit, but for society as a whole to improve. These financial innovations should be applied in the same way. We should take these brilliant minds, have them build robust, fair market making algorithms, and embed them in our market microstructure so that they benefit society as a whole.
Bid-Ask Spread is Already a Liquidity Tax
The market maker spread is essentially a tax on liquidity. The market-maker provides liquidity and for doing so collects the spread. On top of this brokers get their share in the market. In addition, many are throwing around the idea of a Tobin Tax on top of this. Why not just simplify things and allow the government to simply collect the bid ask spread – a liquidity tax and in return be a stable liquidity provider.
While there are obviously concerns I have with such an idea, such as regulatory capture and inefficiency of the government to operate, the more I think about it, the more it makes sense. I also know that this is something that would never go through in lifetime. In any case, this has been something that I have been ruminating on for some time, not going any further in my own head, and wanted to share it with the blogosphere to see what they think.
Now, please, tear it shreds!