Posts this month
A blog on financial markets and their regulation
This week, I read two apparently unrelated things that on later reflection are deeply related:
The link that I see from the esoteric paper to the Libor situation is that markets require very rich communication structures to be viable. One way to facilitate the required amount of multi-way communication is through the high degree of pre-trade and post-trade transparency that is created by trading on an exchange. The other method that was used in the past in various over the counter (OTC) markets was informal communication channels between traders in different firms. Some of these traders might have worked together in the past or might have other personal and social connections. Using various messaging and chat media, these traders used to accomplish an extremely rich communication structure. Of course, these informal communication networks were abused to allow key players to make greater profits (information is money in all markets). After the Global Financial Crisis, regulators shut down the informal communication channels in an attempt to clean up the markets. They succeeded beyond their wildest expectations – there is by definition no manipulation in a market that does not trade at all.
Post crisis, there was a move towards mandatory clearing, but not towards mandatory exchange based trading. This is clearly a huge mistake: the only real alternative to informal communication channels is formal information flows mediated by exchanges. So we see breakdown of previously highly liquid markets. On the other side, central clearing in a market without adequate liquidity and transparency is a prescription for disaster sooner or later. So far, most of the problems have been pushed under the carpet by the central banks that have become market makers of first and last resort in many markets. As they normalize their balance sheets, dysfunctional markets could become a progressively bigger problem.