Page 3 of 4 Health warning for a computer age
By Paul Davidson
Until, and unless, the public's increase in bearishness recedes, the monetary
authority and the market makers can hold that portion of the outstanding liquid
assets that the public does not want to own.
In sum, although the existence of a market maker provides, all other things
being equal, a higher degree of liquidity for the traded assets, this assurance
could dry up in severe "sell" conditions unless the government is willing to
take direct action to provide financial resources to the market maker
sufficiently to encourage the market maker to revive and revitalize financial
markets.
In markets without a market maker, on the other hand, there can be no assurance
that the apparent liquidity of an asset at any
moment of time cannot disappear almost instantaneously. Moreover, in the
absence of a market maker, there is nothing to inspire confidence that someone
is working to try to restore liquidity to the market.
The efficient-market advocates who suggest that one only needs a computer-based
organization of a market are assuming the computer will always search and find
enough participants to buy the security whenever there is a large number of
holders who would want to sell. After all, the "white noise" of buyers and
sellers at prices other than the equilibrium price in efficient markets is
assumed to be normally distributed. Hence, by assumption, there can never be a
shortage of participants on one side or the other of financial markets.
With the failure of MBSs and other financial securitized markets in 2008, it
should be obvious that the computers failed to find sufficient buyers. Moreover
the computer is not programmed to automatically enter into failing markets and
begin purchasing when almost everyone wants to sell at, or near, the last
market price. The investment bankers who organize and sponsor the MBSs and
other financial "securitized" markets will not act as market makers.
These bankers may engage in "price talk" before the market opens [5] to suggest
to their clients what the probable range of today's market clearing price is
likely to be. These "price talk" financial institutions, however, do not put
their money where their mouth is. They are not required to try to make the
market if the potential market clearing "fire-sale" price is significantly
below their "price talk" estimate.
Nevertheless, there are many reports that representatives of these investment
bankers told clients that the holding of these assets were "cash equivalents".
Many holders of these securities believed their holdings were very liquid since
big financial institutions such as Goldman Sachs, Lehman Brothers and Merrill
Lynch were the dealers who organized the markets and normally provided "price
talk".
Participants in the market were often fraudulently led to believe they were
holding very liquid assets. Nevertheless, the absence of a credible market
maker has shown these assets can easily become illiquid. Had these investors
learned the harsh realities of Keynes's LPT, instead of being seduced by the
dolce tones of EMT sirens, they might never have participated in markets whose
liquidity could be merely a fleeting mirage. Should not US security laws and
regulations provide sufficient information, so investors could have made such
an informed decision?
Policy
First, what can be done to prevent future reoccurrences of this widespread
failure of public financial markets? Second, what, if anything else, should be
done to limit any depressing real effects of the current financial market
credit crunch and to avoid another great depression? Third, what actions should
the US government take to prevent the real economy from lingering in a great
recession?
An answer as to how to prevent such securitized market failures in the future
is as follows: According to the web page of the United States Securities and
Exchange Commission (SEC) (www.sec.gov) "The mission of the US Securities and
Exchange Commission is to protect investors, maintain fair, orderly, and
efficient markets, and facilitate capital formation." (Emphasis added).
The SEC web page then goes on to note that the Securities act of 1933 had two
basic objectives: "require that investors receive financial and other
significant information concerning securities being offered for public sales,
and prohibit deceit, misrepresentations, and other frauds in the sale of
securities".
The SEC regulations typically apply to public financial markets where
the buyer and the seller of an asset do not ordinarily identify themselves to
each other. In a public financial market, each buyer purchases from the
impersonal marketplace and each seller sells to the impersonal market. It is
the responsibility of the SEC to assure investors that these public markets are
orderly.
In contrast, a private financial market would be where both the buyer
and the seller of the any financial asset are identified to each other. For
example, bank loans are typically a private market transaction that would not
come under the purview of the SEC. In normal times, there should be no resale
market for securities created in private financial markets. The issued asset
from a transaction in private a market traditionally has been an illiquid
asset.
On its web page, the Securities and Exchange Commission also declares that: "As
more and more first-time investors turn to the markets to help secure their
futures, pay for homes, and send children to college, our investor protection
mission is more compelling than ever."
Given the current experience of contagious failed and failing public financial
markets, it would appear that the SEC has been lax in pursuing its stated
mission of investor protection. Accordingly, the United States Congress should
require the SEC to enforce diligently the following rules: 1. Public notice of potential illiquidity for public markets that do not
have a credible market maker. In the last quarter of a century,
large financial underwriters have created public markets, which, via
securitization, appeared to convert long-term debt instruments (some of them
very illiquid, such as mortgages) into the virtual equivalent of high-yield,
very liquid money market funds and other short-term deposit accounts. Given the
celebrated status of the investment bank underwriters of these securities and
the statements of their representatives to clients, individual investors were
led to believe that they could liquidate their position at an orderly change in
price from the publicly announced clearing price of the last public auction.
This perceived high degree of liquidity for these assets has now proven to be
illusionary. Purchasers might have recognized the potential low degree of
liquidity associated with these assets if the buyers were informed that,
although the organizer-underwriter could buy for their own account, they were
not obligated to maintain an orderly market.
Since the mandate of the SEC is to assure orderly public financial markets, and
"require that investors receive financial and other significant information
concerning securities being offered for public sales, and prohibit deceit,
misrepresentations, .... in the sale of securities", it is would seem obvious
that all public financial markets that are organized without the existence of a
credible market maker should, either (a) be shut down because of the potential
for disorderliness, or (b) at a minimum, information regarding the potential
illiquidity of such assets should be widely advertised and made part of
essential information that must be given to each purchaser of the asset being
traded.
The draconian action suggested in (a) above is likely to meet with severe
political resistance, as the financial community will argue that in a global
economy with the ease of electronic transfer of funds, a prohibition of this
sort would merely encourage investors looking for higher yields to deal with
foreign financial markets and underwriters to the detriment of domestic
financial institutions and domestic industries trying to obtain capital
funding.
Of course, if governments were to reform the international payments system [6]
in a manner similar to the IMCU proposal of Chapter 10 in Keynes this
could prevent US residents from trading in foreign financial markets that the
US deemed detrimental to American firms that obeyed SEC rules while foreign
firms did not follow SEC rules.
As long as the current global payments system remains in effect, however, and
there is a fear of loss of jobs and profits for American firms in the FIRE
industries, then the SEC could permit the existence of public financial markets
without a credible market maker as long as the SEC required the organizers of
such markets to clearly advertise the possible loss of liquidity that can occur
to holders of assets traded in these markets.
A civilized society does not believe in caveat emptor for markets where
products are sold that can have terribly adverse health effects on the
purchaser. Despite the widespread public information that smoking is a
tremendous health hazard, government regulations still require cigarette
companies to print in bold letters on each package of cigarettes the caution
warning that "Smoking can be injurious to your health".
In a similar manner, any purchases on an organized public financial market that
does not have a credible market maker can have serious financial health effects
on the purchasers. Accordingly, the SEC should require the following warning
to
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