The Fed and Regulators Should Draw the Veil

By: Michael Ashton | Mon, Sep 9, 2013
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When I remark, from time to time, that I think the Fed has made a mistake in increasing transparency of its deliberations and actions, people occasionally look at me as if I had come out opposed to motherhood or apple pie. But my point is that transparency is good if it permanently decreases risk...but it doesn't.

What matters is how market actors respond to increased transparency. It is much like the old debate about whether football players ought to wear helmets. It is clear that helmets decrease the likelihood of brain damage in any given collision, compared to the un-helmeted rider in an identical collision. But it is also clear that as helmets have gotten better and better, football players have played faster and faster, with more abandon, and lead with their heads a lot more than they did when all they had was a leather cap. The net effect is indeterminate.¹

In markets, increased transparency from a central bank or regulator leads to increased leverage in a very direct way. The central bank's dial is for transparency, but the investor's dial is for risk appetite and when the central bank turns its dial it does not change the investor's risk preferences. The result is that increasing transparency, which decreases the risk at any given leverage and at any particular moment, leads to higher levels of leverage, which lowers the tolerance for error. And, as we have seen, central banks and regulators are quite prone to error.

In an interesting way, this is tied into the volume question. The chart below (source: Bloomberg) shows rolling 250-trading-day volume for the NYSE in billions of shares. As has been well-documented, market volumes have been steadily declining for years.

250-day rolling Equity Market Volumes

As we have mentioned here before, there are lots of excuses for lower market volumes on the major exchanges, and probably many of those excuses are part of the answer. But we can no longer simply attribute this to the movement of volumes to "dark pools." There is simply less going on in the markets, whether in rates or in equities. Ask the dealers. Dodd-Frank and the Volcker Rule are simply decimating volumes. And this is not just bad for dealers, it is bad for everyone.

When a trade happens, there is information revealed. Indeed, in some markets a meaningful proportion of the volume transacted is between dealers who are testing the market to get more information. More trades means that there are more quanta of information. More quanta of information produces more confidence in prices. More confidence in prices means more support for the current prices, and more de facto liquidity.

Think of it this way. If a bond has never traded, and two counterparties come together to trade some at a price of 103, what is your estimate of the true market for another trade? Is it one tick around 103? If so, then you are displaying almost outrageous overconfidence - one data point between two counterparties, about whose motivations you know precisely nothing, tells you almost zero about what the true market (by which I mean, the prices at which you could buy, for an offer, or sell, for a bid, a typical-sized transaction) is, and even less about what the support market (by which I mean the prices at which you could transact in substantially larger sizes) is. And so bid/offer spreads, whether quoted on-screen or over-the-counter from a dealer in the security, must be wider since the market-maker just doesn't know as much as he would if volumes were higher - and, more to the point, the market must be wider because the client who initiates the trade is likely to know more than the market-maker does about the right price. This is because the market-maker must make a market whether or not he knows the fair price, but the buyer or seller doesn't have to trade unless he/she believes the fair price is outside of the quoted range. Of course, that's where the information comes from: if the offer is lifted, it means someone is saying "I think the fair price is higher than your offer," and that is information.

I mention this today for several reasons. First, because it has been a while since I showed the NYSE volumes chart in a while. Second, because there was an article on Bloomberg today entitled "Professor Who Helped Pop Junk Bubble Says Trace Slows Trade" which ties transparency to diminished volumes. To the extent that Trace produces true transparency and reduces the need for "testing" trades, it is a good thing...but then we should see tighter spreads for size, and while the study is suggestive it isn't conclusive on this point. More interestingly, the professor in question also made the point that "less trading may hurt investors if, instead of reducing 'noise' from the market, the reduction slows how quickly new information alters prices." And this point is also key:

"...if the decrease in trading activity is the result of dealers' unwillingness to hold inventory, transparency will have caused a reduction in the range of investing opportunities. That is, even if a decline in price dispersion reflects a decrease in transaction costs, the concomitant decrease in trading activity could reflect an increased cost of transacting due to the inability to complete trades."

So transparency, it seems, is not an unalloyed positive like apple pie. But lower trading volumes, which are partly the result of transparency (and partly the result of poorly-conceived rules like Dodd-Frank, the Volcker Rule, and Basel III), are very probably bad for everyone. This doesn't just affect hedge funds. Markets which are deep and liquid are much less prone to sudden price breaks. With the US equity market still floating near the highs despite rapid increases in nominal and real interest rates and worst-ever outflows from ETFs last month, this is a point that may be more than academic at the moment.


¹However, no one disputes that the faster game is a lot more fun to watch. What I suspect has happened is that the introduction of hard-sided helmets probably increased injuries until players essentially reached maximum speed/recklessness, after which point the further improvements in helmet design probably started to make the game safer again. But it is really hard to prove that.

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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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