One of the arguments apparently being made in Washington by those who oppose regulation of credit default swaps is that it would reduce liquidity and that of course would be a terrible thing.
My impression is that no one has endeavored to put metrics on this assertion (as in how and where liquidity would be reduced and what the consequences would be). However, just because a certain amount of liquidity is good, it does not necessarily follow that more is always better. Recall Keynes’ remark, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done.” Excessive liquidity can lead to precisely such an outcome. (Note we recently discussed evidence of harm caused by CDS, and asked readers for examples of where they were beneficial, and what sort of transactions required customization. The response was underwhelming).
We are suffering a hangover from just such a period. One of the comments I have heard from debt market participants in the bubble era was that they were faced with a ‘wall of liquidity”, tons of money looking for places to park it. And some of that appeared to be the direct result of credit default swaps. CDS allowed banks in Europe to circumvent capital requirements, enabled investment banks to accelerate profits from deals into the current period by (in theory) defeasing risk, allowed banks to extend bigger loans than they would have otherwise by hedging some of the risk. The net effect was that a lot of players achieved higher gearing than they would have otherwise.
Another effect of high liquidity is to lower bid-ask spreads. Until recently, greater efficiency (which is what you get with lower transaction costs) is seen as a boon. But lower transaction costs also fuel speculative activity. Behavioral finance studies have found that even in simple bidding setting, participants create bubbles. Low transaction costs and the appearance of abundant liquidity supports short-term, momentum based trading strategies, with participants believing they can find the exits when they need to (recall former Citi CEO Chuck Prince’s infamous “still dancing” remark). Higher frictional costs lead investors to think twice about adding and exiting positions.
Reader thought on this issue are encouraged. How does one judge when liquidity has become excessive, when the ease of trading starts to distort fundamental activity, or adjacent markets? Or is it like pornography, difficult to define objectively, but easy to identify?