By Doug Gentry, on December 30th, 2011
Was it Popeye’s friend, Wimpy, who kept asking for a hamburger on credit? Today’s credit markets are anything but robust, with reduced demand and supply for borrowed funds. Always eager to find obscure terms for modern dilemmas, economists refer to this condition as a liquidity trap. With a little prodding from Facebook friend and neighbor, Patrick, we’ll give the concept a once over.
Jumping to the conclusion (and resisting the academic approach of a slow, careful warm-up) there is bad news and good news about liquidity traps. The bad news is that they make it difficult for the Federal Reserve to execute monetary policy. Creating 100s of billions of dollars has a muted impact on our economic recovery. The good news is that the liquidity trap dampens the significant inflation we might expect with the creation of all that money.
OK, back to the beginning. During times of slow or no growth and high unemployment the Federal Reserve can create/inject money, largely by increasing reserves that banks have in their accounts with the Fed. They can do this by buying U.S. treasury bonds on the open market, or even by buying troubled/toxic assets from banks. This increase in the supply of money allows interest rates to fall, which in term spurs demand for more consumption and investment. This is classic monetary policy. With mild downturns this is often enough to increase growth and kick start the economy. For the most recent 2007-2009 recession the Fed took these actions, a number of times in a number of ways, and those actions were not sufficient. Now the target short term interest rate – the Fed Funds rate – is essentially at zero. The Fed can’t lower the interest rates any further. Here’s a graph of the Fed Funds rate since 1980. The big peak at the beginning of the graph was the result of aggressive Fed action to contain inflation. Now, though, the rate has sunk to the very floor.
 Fed Funds Rate – St. Louis FRED database One thing that is happening is that while reserves are building up in our financial system, the banks are holding on to them rather than increasing their lending. Some argue that the banks are using the added funds to improve their balance sheets, which were hurt by the dramatic loss in value of securitized mortgages and other derivative assets, and to build up enough cash to pay executive bonuses. The banks argue that demand for credit by qualified borrowers is low. I don’t put much credence in the latter explanation. One apt analogy for this situation is that the Fed is trying to push on the end of a string, in order to get the economy going.
There is another layer to the liquidity trap concept, and that has to do with the buying public’s (people and business) expectation for inflation. The theory goes that if buyers expect inflation in the future, they will increase buying now. They expect the value of their cash or savings to go down during inflationary times, so they seek to use it now, while its value is still high. This works with traditional monetary policy where an injection of money would be expected to increase inflationary pressures.
On the other hand if purchasers believe that inflation will be controlled, then there is less pressure to buy now. That’s what is happening now. Despite what some politicians suggest, inflation is not right around the corner, and buyers are in no hurry to convert their cash into goods. We see evidence of this with the continuing low interest rates on U.S. bonds. Expectations of high inflation would push those interest rates up. Low inflation expectations, even in the face of increasing money supply is another symptom of a liquidity trap.
This scenario played out, to grim effect, in Japan in the 1990s, as their central bank poured money into the banking system and no one responded. Their “lost decade” was one of almost zero growth.
This paper by a New York Federal Reserve staff economist explains things in more detail, complete with impenetrable equations.
By Ajay Shah, on September 19th, 2011
Market making versus the electronic limit order book
 Exchanges in India all operate as electronic limit order book markets. There are no `market makers’; there is just a publicly visible limit order book. Anyone is free to supply liquidity, by placing limit orders. The person who places market orders is the consumer of liquidity: he pays market impact cost. [A guide to the jargon]. Prior to the rise of the anonymous limit order book, there used to be a great deal of effort on thinking about the market maker. Market makers played a big role in many old markets. E.g. at the NYSE, the `specialist’ was obliged to provide liquidity. RBI established `primary dealers’ thinking that they would provide liquidity.
These market structures involved complicated problems of measuring the liquidity provision by market makers, correctly compensating them, avoiding monopoly power in the hands of the market market, and enforcing against market manipulation by the market maker. The rise of the open electronic order book cut through this Gordian knot.
For many years, there used to be a debate about whether the anonymous open limit order book market (where anyone can provide liquidity) is better or worse than a market maker market (where limit orders can only be placed by one or more market makers). That debate died down in the 1990s with the success of the electronic limit order book. Market making on the electronic limit order book
But even on a limit order book, does it make sense to pay one or more market makers to provide liquidity? The public would be free to place limit orders, but one or more market makers would be paid to place limit orders.
The positive argument runs like this. In the life of every contract, at first there is a lack of liquidity as various market participants are reluctant to take the plunge and trade on an illiquid contract. This leads to a chicken and egg problem. Illiquidity inhibits participation, and the lack of participation is illiquidity.
From a regulatory perspectives, exchanges might try to make payments for liquidity provision (or outright turnover) by various underhand means. If that is going to happen, then it is better to have this come out into the open.
But there are also important problems that can come out by going down this route. The resources that an exchange puts into portraying tight spreads or high turnover could potentially be used to improve services for customers. Market participants would make wrong decisions about an investment decision when they see a product as looking liquid on screen, whereas this liquidity is actually artificial: the screen would be falsely portraying liquidity. When exchanges compete on payments to market makers, this can degenerate into a slugfest where the deepest pockets win.
The artificial liquidity pushed by mercenary market makers would tend to lull the exchange into complacence. In the absence of market making, the exchange would run harder to solve problems of market mechanisms and contract design, and to get the word out about the contract.
Recent developments in India
On 2 June 2011, SEBI chose to move ahead with the specification of a `Liquidity Enhancement Scheme’ (LES).
By these rules, LES is applicable for individual stocks where the trading volume on the last 60 days is below 0.1 per cent of the market capitalisation. (How would this be scaled to derivatives such as currency futures, where market capitalisation cannot be defined?) I think this makes sense. The LES would be used to kickstart liquidity when it is abysmal. The moment a small amount of liquidity comes about, the LES would step aside.
Based on these rules, NSE announced a program for market making on the derivatives products recently launched at the exchange: on the S&P 500 and the Dow Jones Industrial Average (launched in partnership with the Chicago Mercantile Exchange). These incentives are over and above the absence of charges by the exchange. I was disappointed to see a payment based on mere turnover. This would give the market maker an incentive to do circular trading and thus show a lot of trades. But turnover is not liquidity.
This program came into effect on 15 September. It may matter more in the coming week, given that new contract series start trading from tomorrow. Will it matter? How will we know that it mattered?
Derivatives on the S&P 500 and the Dow Jones indexes have gotten off to a surprisingly good start, even though there was no such program. This has perhaps been helped by unusual levels of volatility in the US after the launch of these contracts.
The early days of a contract can be a rollicking ride and even after these time-series fall into place, it will not be easy to tell whether LES was useful in the history of these contracts or not.
Similar thinking is taking place at BSE also: See Will BSE’s biggest initiative work? by Mobis Philipose in Mint. The text there — obligations such as providing two-way continuous quotes within specified parameters for quote size and spread — sounds good, but here also there are payments per crore of turnover. By and large, the payments being made at BSE look much bigger than those at NSE.
In the case of BSE, if LES is able to lift BSE out of zero market share in derivatives trading, even after the six month period has expired, then it would be a clear proof that the LES helped. So this experiment is unlike that of NSE where it will be hard to evaluate whether or not the LES mattered.
By Ajay Shah, on June 30th, 2011
The problem of measuring the price
In a liquid and transparent financial market, there is no doubt about the price. There is high pre-trade transparency, because orders are visible on the limit order book, and the best estimate of the true price is (bid+offer)/2. You glance at the screen and you know what is the price.
In a non-transparent market, it is hard to know the true price. Special schemes have to be constructed in order to measure the price. Price measurement does not happen `for free’ as a minor side effect of the very trading process.
Why price measurement matters
As a thumb-rule, the best design for a derivatives contract is to use cash settlement, as long as you can be pretty certain about observing the price. If you can’t measure the price, then physical settlement is better.
Cash settlement is a great technology. But it requires sound measurement of the price.
Measuring price on an OTC market
In an OTC market, information is not visible at a glance. It is dispersed. Many traders have private information about the price, but
you do not. If you could setup an electronic order book, you would see bid and offer at a glance: these are the prices at which a small buy and a small sell transaction could be done. On an OTC market, the dealer has a sense about where the market is, but you don’t. So a natural strategy is that of asking the dealer what he is seeing.
Dealers have positions on the market, so we have to worry about what they say. Standard schemes used involve removing extreme
observations, and thus coming up with a more robust price measure. These schemes have been used in India with the NSE MIBOR (the dominant price measure on the interest rate swaps market), the CMIE measurement of commodity spot prices for NCDEX, etc.
RBI’s measurement of the INR/USD exchange rate
In India, RBI is an information producer in reporting the INR/USD exchange rate at 12 noon. This `official RBI price’ is widely used in
computing the settlement price for cash-settled derivatives on the rupee. It is used for the official closing price on the NSE currency futures/options market, which in many ways is shaping up as the main market where the INR exchange rate is discovered. As an
example, yesterday (an expiration day), the open interest closed at $7.2 billion, and turnover was $6.2 billion.
RBI has not had a formal methodology for how this price is computed and reported.
I have always been a bit uncomfortable with RBI producing this vital information, since RBI has many other goals which can conflict
with the goal of producing high quality information. But for a while, this seemed to be working.
New methodology at RBI
On 1 July, their methodology will change to something new:
- They will choose a random five-minute window from 10:30 to 12:30 (i.e. a two-hour window).
- The reference rate will be computed using these five minutes.
- It will be released at 13:00.
I cannot imagine the logic which led up to this, but I have to say that this is not a good idea.
A two hour window is a lot of time in the life of a market. The RBI reference rate is then no longer a reference rate of the market. It is
a measure of the price at a randomly chosen time in that window. This makes it much less informative.
As an analogy, imagine if the official NSE closing price for Nifty was plucked out of a randomly chosen time from 2:30 PM to 3:30
PM. This would be a lot less informative as compared with the present methodology (value weighted average of all trades from 3 PM to 3:30 PM). It would be even better if NSE were to do a call auction from 3:15 PM to 3:30 PM and report that price as the official closing price. That would be sharp and interpretable.
All cash derivatives settling on the RBI reference rate will now suffer from a new source of uncertainty: the randomly chosen time at
which the price is reported. The cash-and-carry arbitrageur needs to sell his spot position at the exact time at which the derivatives
expire. In the case of the Nifty futures, there is a simple trading strategy which roughly approximates the Nifty closing price: In each
of the last 30 minutes, do 1/30 of your required trade. This is typically automated, i.e. it requires algorithmic trading, but it’s fully feasible.
With a randomly chosen timepoint over a two hour horizon, the arbitrageur does not know when to closeout. This will exert a negative impact on pricing efficiency and thus basis risk on the derivatives market.
If the INR/USD exchange rate is a random walk in trading time, then the 9% annualised volatility maps to a standard deviation of 28 basis points over a two hour horizon. On a base of Rs.45 a dollar, this is a standard deviation of 12.6 paisa. This is quite a bit for traders and arbitrageurs. These small issues have a disproportionate impact in contaminating market efficiency.
But wait. There are some people who know at what time the pricing is done: the banks who are polled! So suppose there is a fixed panel of banks who are asked by RBI. The moment the RBI phone call comes in, they closeout. These banks will find it profitable to do currency arbitrage while others are not. Such shifts in the currency arbitrage constitute a distortion induced by RBI’s new method of price measurement.
Lessons
RBI needs to cultivate improved knowledge of finance amidst its staff.
This illustrates the importance of legal process in rule-making. If RBI had gone through a formal notice-and-comment process, then they could have heard from external experts and desisted from doing this. I wasn’t able to find a document on the RBI website explaining the rationale for what is being done.
Information production should be done by specialised information organisations. If information is produced by people who have other conflicting interests, then such sub-optimal decisions are more likely to arise.
Alternative information producers, such as Reuters, should leap into this opportunity by producing a better INR/USD reference
rate. FEDAI already has an alternative reference rate. We should all switch away from the RBI reference rate towards alternatives.
Unfortunately, many people in the trade are fearful of the RBI and would not evaluate alternatives rationally. This tells us two
things. First, RBI needs to be enveloped in the rule of law so that there is no fear of RBI on the part of market participants. Second,
RBI should not be a producer of information. As long as two private agencies are producing INR/USD reference rates, the decision in the derivatives trade about what information measure to use will be based on technical merits alone. If someone then tries to come up with a scheme where a randomly chosen time over a two hour window is used for the measurement, his market share will go to zero.
By Claus Vistesen, on June 24th, 2011
Not too long ago, I compared the Japanese economy to a bumblebee because of the economy’s ability to keep on chucking along even as the government debt/GDP ratio stormed above the 200% mark. I am starting to think that the same comparison might be warranted too in the case of my home country.
One striking aspect of the Danish economy that any economist following the discourse on Denmark must be pondering is that despite the widespread idea that Denmark has a serious productivity problem relative to its peers, it has not yet shown up in the data. Denmark is still running a sizeable trade as well as income surplus which together adds up to a tasty current account surplus.
So what gives and can this situation be maintained?
The reason that I have been forced to think about this was today’s report by Bloomie that the Danish bank and mortgate originator Nykredit announced that it would actively seek to widen its international investor base for covered bonds backed by mortgages of which the bank is Europe’s largest holder and which contributes to making the Danish market for mortgages one of the world’s biggest.
Basically, the problem for Danish financial institutions is that under the new Basel rules, covered bonds backed by mortgages will be treated as less liquid than government bonds (and thus less liquid than is currently the case) and thus Nykredit et al will be left holding way too many of these securities. The problem in a nutshell is this;
Denmark is leading efforts to persuade the European Union to ease liquidity rules set by the Basel Committee on Banking Supervision that the Nordic country says penalize the world’s third-largest mortgage-bond market. While the EU has signaled it may accommodate some of the demands, standards scheduled to take effect by 2015 are still likely to treat covered bonds as less liquid assets than government debt, Engberg Jensen said.
“I don’t think we can totally avoid a haircut” on how banks treat covered bonds in their liquid assets, he said. “I don’t think that we’ll end up with rules where covered bonds and government bonds are equal.” This means “we need to find a broader investor base. We want to be stronger in Europe and we have also started in the Middle East and the Far East. We’ve had investors for many years in the U.S. and Europe.”
Under the new rules, banks must abide to a limit of 40% in terms of how much of the securities portfolio that can be made up by (mortgage) covered bonds which leads to the obvious result that …
“If we get the new rules, most Danish banks will have to restructure to sell mortgage bonds and buy government bonds,” Engberg Jensen said. While Danish banks have relied on the country’s covered bonds to generate liquid assets, lenders in Germany and Asia have room to purchase the securities without breaching Basel’s 40 percent limit, Nykredit estimates. The company wants to sell its bonds to banks in those regions to make up for the selloff it expects to see in Denmark, Nykredit Group Managing Director Karsten Knudsen said in the same interview.
Denmark has a problem here, a big one in my opinion and the only chart you need to look at is the following.
(click on picture for better viewing)
Despite the crisis, Denmark has not delevered substantially and mortgage debt remains a sizeable portion of GDP; 134% by my calculations in 2010. And this is mortgage debt alone and thus leaves out a large private debt burden, all corporate debt as well as a growing government debt.
It is important to understand where Denmark is here. Denmark is like Spain, Ireland and Australia with large a large private debt burden which will only really make itself felt once the government has to assume the final bill (think Ireland here). Now, at this point my compatriots would know doubt file this post under the “one flew over the (…)’s nest” folder as comparing Denmark with the countries made above seem more than outrageous. But try to get the main point here. Denmark’s main debt problem is in the private sector and given the Irish experience, once the sovereign has to plug a hole in the domestic financial system, it is the total debt that matters and not merely the government debt.
Recently, the EU commission issued a report with a stark warning to Danish policy makers that both the size and structure of the housing market with the majority of loans made up by variable interest rate and no-amortisation/down payment (often both in the same loan!) represented a current and future source of instability. The Danish central bank has even suggested to phase out these loans entirely even if it seems that such a proposal has not got political backing in the Danish parliament regardless of the result of this year’s election.
According to Bloomberg, Nykredit and others have noted that they will try to separate the way they funds their adjustable rate mortgage portfolio from their fixed rate portfolio. This is almost hilarious in its uselessness in my opinion since the main problem here is not a flow issue but a stock issue as evidenced by the chart above.
When all is said, I think you should take away the following point from this.
Essentially, if Danish mortgage originators start selling bonds to foreign investors for the obvious rational reason that they need to abide to new capital requirement rules it will mean a defacto deterioration of the current account (not necessarily a problem, just a fact when you sell securities abroad). So, the question is; how willing will foreigners be to finance one of the most overlevered housing markets in the world and at what yields?
When I run the scenario in my head, I end up in a situation where it might be quite difficult to push Danish covered bonds to foreigners at acceptable prices, liquidity will dry up and re-financing will get more difficult. In addition, if yields go up prices (i.e. house prices) will fall and exacerbate the difficulty in pushing the securities since the prices on the underlying collateral (i.e. property will go down).
Now, far be it from me to attempt to put Denmark in a club to which it does not belong but think about it for a minute. The road map for how a Danish government might be forced to issue government bonds and swap them for unsellable covered bonds in order to allow its financial institutions to abide to the Basel rules is an almost sinister way in which the Danish sovereign ultimately may end up being on the hook for the total stock of debt in the society, just as we have seen elsewhere.
Am I seeing ghosts? Perhaps, but consider yourself warned.
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By Christopher Briem, on November 24th, 2010
So in reading the WDUQ snippet on the otherwise boring and esoteric machinations of public finance: 2 Votes move Bond Plan Forward, is a awfully important factoid. In it there is a mention of the size and scale of the ‘illiquid assets’ held by the City of Pittsburgh combined municipal pension fund. The line I note is ” some $50 million already in the pension fund in high risk investments that the PMRS did not use in previous calculations“.
So we have a $50 million number in the record now. Progress is progress.
So the pension fund which is as woefully underfunded as a pension fund can be, that is at risk to need all of its remaining cash in the very near future, somehow has roughly a fifth of it’s assets invested in what are as kindly as possible characterized as “high risk”. Can anyone think of a justification for that? Can anyone figure why these assets are not being identified? Can anyone verify that these $50 million in assets are actually worth $50 million currently??
So let’s be clear. High risk and illiquid investments are not only not illegal, they are common enough that the GFOA has guidance on their use in pension fund investments. So the existance of illiquid assets is not the issue, yet the magnitude of these investments in such a vastly underfunded pension fund is arguably malfeasance and I would be glad to argue the point. That roughly $50 million of such assets exist in a pension fund holding give or take $270 million is a huge proportion for a fund as distressed as it is.
The GFOA guidance has what may be the most understated advice for these assets. Footnote 5 in the previous linked reference is:
Due to the increased risk of misstatement inherent with these investments resulting from incorrect valuation, part of the increased due diligence could be to obtain a reasonable understanding of the procedures that may be applied to them during the independent audit of the financial statements.
There it all is in a nutshell. “risk of misstatement”… “incorrect valuation”… anyone have a warm fuzzy that the numbers being cited represent valid valutions of the assets involved? If you read through to the end you get GFOA’s admittedly broad guidance on use of such investments which is that they should: “exercise extreme prudence and appropriate due diligenge.” You can read the document to see the specifics of what that appropriate due dilligence should involve. Since we have no idea the details, do we know what due dilligence has actually been implemented.
What is a bit scary in the context of all of this. All I have been able to glean on this personally are some comments made to me that the pension fund has in recent years been bringing down their investments in these high risk, or illiquid, assets. I can neither verify or dispute that. If true,and if it still has $50 million invested this way, then it begs the question of how big big a percentage these high risk investments made up of the pension fund in the past?
and I know I am a broken record….. but will someone please please do a follow up of this story: City acts to curb further pension losses. I’ll stand on my head if it helps. Do I need to wander around Downtown aimlessly wearing those big dual placards over my shoulders you used to see folks wearing… Are any of those folks still around? Problem is that the placards would have to have messages written in tiny type to explain it all. People would think I was walking around with the Rosetta Stone or something.
By Claus Vistesen, on August 6th, 2010
Team Macro Man has a nice perspective on what deflation might mean in the OECD context and it is difficult to disagree with the underlying rationale.
One sector that is glaringly not singing to the Deflationistas’ hymn sheet is commodities. While a rapidly-growing global population continues to compete, like bacteria on a Petri dish, for the basic resources of food and energy, the input component to basic living will keep local prices firm even in an environment of other localised deflationary pressures.
The world is still steadily competing for raw materials, so any slow down in the West can only express deflation through lower wages as competition for jobs tightens and hence labour cost inputs fall. So whilst service sector (higher labour component) may see a higher relative price deflation, the basic cost of survival, food and energy to the individual stays the same, or rises as we are now seeing.
That isn’t an individual enjoying deflation, that’s an individual suffering poverty.
I remain inclined to believe that the biggest problem for most OECD economies in the coming decades will be deflation (and the subsequent increase in the value of real debt) rather than inflation. But there is a world outside OECD too and especially commodities could very well be a source of inflation and thus in some sense stagflation (with the added spice that our relative wage in the West may fall at the same time)
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If you like me are prone to the occasional what the h’ck is going here mantle; this rap up by Gwen Robinson at FT Alphaville provides a good overview of the recent flurry. Highly recommended as the first read this Friday morning or as weekend lecture.
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Jean Tirole is professor in Economics at Toulouse University and back in September 2009 he penned a very interesting article on illiquidity and what it means for a balance sheet (of a bank) to be liquid and illiquid.
The recent crisis was characterized by massive illiquidity. This paper reviews what we know and don’t know about illiquidity and all its friends: market freezes, fire sales, contagion, and ultimately insolvencies and bailouts. It first explains why liquidity cannot easily be apprehended through a single statistics, and asks whether liquidity should be regulated given that a capital adequacy requirement is already in place. The paper then analyzes market breakdowns due to either adverse selection or shortages of financial muscle, and explains why such breakdowns are endogenous to balance sheet choices and to information acquisition. It then looks at what economics can contribute to the debate on systemic risk and its containment. Finally, the paper takes a macroeconomic perspective, discusses shortages of aggregate liquidity and analyses how market value accounting and capital adequacy should react to asset prices. It concludes with a topical form of liquidity provision, monetary bailouts and recapitalizations, and analyses optimal combinations thereof; it stresses the need for macroprudential
policies.
The best academic read I have a had in a long time.
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Eliana Marino takes a look a migration in the Baltics and tells one of the great unsung stories of this crisis and what it means when you lose your working age people to net migration;
- emigration of working age population makes the demographic burden increase: the number of inactive people (children and retired people) exceeds the number of active people, creating serious challenges for the sustainability of the welfare system;
- the most part of the outflows consists of working age population (from 15 to 65 years old) that includes people in reproductive age (from 15 to 49 years old). A huge number of emigrants in this particular age group means a further reduction of the natural increase of the population. In fact, they will probably have their children abroad or the migration decision itself will discourage the creation of numerous families.
I need to write a paper on this!
By Ajay Shah, on May 21st, 2010
In continuation of this blog post on the big quantities visible on the order book of the NSE currency futures market, I got hold of order book information for one recent timepoint (10:32 AM on 9 April) for three April expiry futures: Nifty, INR/USD and Reliance. This is not as good as looking at information for today or yesterday, but it’s quite instructive.
Theory teaches us that liquidity varies with volatility and asymmetric information. Using daily returns for all points seen in 2010, the three vols (all annualised) for these three underlyings work out to:
- INR/USD: 6.6%
- Nifty: 15.2%
- Reliance: 24.5%
So we expect Reliance will be the least liquid, given the asymmetric information which afflicts individual firms and given the high volatility of Reliance. Both Nifty and INR/USD will have better liquidity since they are macroeconomic underlyings (with low asymmetric information). Of these, INR/USD will fare the best because it has a low volatility.
The data that I got was for the top 20 prices in the order book. This shows the following picture of how impact cost when buying (in basis points) varies with transaction size (measured in million rupees):
The blue line is the impact cost of Reliance. The quantity available in the top 20 prices is low, and the impact cost therein goes up rapidly from a spread of around 1 basis point to around 9 basis points at the end. This is the combination of high asymmetric information and high volatility.
The black line is the impact cost for the April Nifty futures. Within the top 20 prices, roughly Rs.100 million or $2 million was available at this time. A single market order for $1 million would get done at roughly 2 basis points and a single market order for $2 million would get done in a bit less than 3 basis points.
The INR/USD futures yields a lot of quantity within the top 20 prices: all the way out to Rs.250 million or roughly $5 million or 5000 contracts. The impact cost for $1 million is below 1 basis point and that at $2 million is below 2 basis points – so this is more liquid than the currency forward. I found it interesting that at $2 million (i.e. Rs.100 million) the impact cost for Nifty and for the INR/USD were not that different.
To look at these orderbooks in realtime, use the links in the previous blog post.
By Trace Mayer, on May 13th, 2010
On 6 May 2010 the DOW dropped a massive 600 points in a mere seven minutes and at one point was down 998.50 points which is the largest nominal drop ever. One of the reasons for this increased volatility is the knowledge of all major market participants that their assets are neither safe nor liquid yet the greed to engage in speculation. As the true state of the worldwide financial markets and their fake liquidity increasingly permeates the zeitgeist more and more individuals will simply withdraw their capital and store it is the monetary metals. 
Those who have followed RunToGold for a while have been adequately warned. For example, on 9 October 2009 I was interviewed on BNN and suggested that gold would reach $1,300 in Q2 2010 as the credit crisis intensifies. Now gold is within striking distance. On 7 February 2010 I warned of the approaching Laboon of sovereign debt default and Euro evaporation. Now it is happening. On 27 July 2009 I warned of the coming market crash. While the market is crashing when priced in gold it has still remained fairly orderly and but for The President’s Working Group On Financial Markets it would be a lot more chaotic.
VOLATILITY
When the financial markets experience unusual palpitations then those closely involved often flee for safety and liquidity. With high frequency trading powered by computer algorithms the result is a gigantic electronic herd moving at the speed of light. The result is an explosion in the VIX or CBOE Market Volatility Index.
… value and price are completely discrete.
The higher the VIX the more difficult it is for the entrepreneur, the individual that creates real wealth by providing the goods and services the economy desires, because making mental calculations of value becomes more difficult and therefore decisions to allocate capital become based on more arbitrary premises. In this current economy, value and price are completely discrete.
The end result is that holders of capital, instead of taking risk and buying an ice cream machine or building a new factory, buy gold, silver and platinum while waiting for calmer days. When the devaluation of intrinsically worthless fiat currencies happens it will likely be extremely quick.
THE GREAT CREDIT CONTRACTION
 I really wish this liquidity pyramid could accurately convey all I want but it gets the main point across. During a credit contraction capital, both real and fictitious, burrows down the pyramid into safer and more liquid assets. The illusory capital evaporates.
… the riots in Greece are the prelude not the encore …
What happened on Thursday? Capital burrowed into FRN$ Treasuries and gold. Gold is now perched atop a near record all-time high around $1,210 per ounce.
As reported by Bloomberg, the EU’s $645B fund to fend off the ‘wolfpack’ will be like a decrepit brontosaurus trying to fend off 100+ hungry velociraptors. Europe is too old, too beauracratic, too slow and fighting economic law to be able to mount a sufficient defense. The little baby velociraptors, hatched with the merger of bank, currency and state through ignoring Article 1 Section 10 Clause 1 of the United States Constitution and the establishment of the unconstitutional Federal Reserve, have now grown up and they have unlimited avarice to feed.
But I think the real value is to be found in buying platinum which, during the past week, got cheaper when priced in gold. A likely scenario will be a summer consolidation or pullback in gold, silver and platinum and then starting in August the trek towards $1,650 gold with the bulk of the upleg happening in November.
There will come a time to buy the S&P 500 and real estate with one’s monetary metals but that time is still a few years away. In the meantime, the name of the game is to retain the capital and purchasing power already accumulated. Keep in mind, the riots in Greece are the prelude not the encore and will be coming to a city nearby before The Great Credit Contraction is over.
CONCLUSION
The entire worldwide financial and economic system are built on an illusion. Neither I nor other prepared individuals really care if the stock market crashes 700 points in ten minutes. What is going on is fairly simple economic law which I discuss in The Great Credit Contraction. While the time to buy the precious metals at a good value was earlier there is still incredible reasons to at least have some material portion of one’s net worth allocated to them.
After all, whether the fire of inflation or even hyperinflation or the ice of deflation that freezes the global economy in its tracks a holder of capital will be protected when ensconced within a golden forcefield. And the monetary metals can do wonders for reducing blood pressure when watching Iceland, Greece, New York or LA on television.
DISCLOSURES: Long physical gold, silver and platinum with no interest in DOW, S&P 500, the problematic SLV ETF, gold ETF or the platinum ETFs.
By Ajay Shah, on November 27th, 2009
In recent months, a sense has emerged that the exchange-traded currency futures market in India is more liquid than the corresponding contract traded OTC (i.e. the forward market). As an example, we examine a dataset from NSE of 28,797 observations of data – one observation per second – from 3 November 2009, for the November expiry. The effective spread for a transaction of $1 million (i.e. 1000 contracts) is calculated, in the units of paisa. This dataset has the following summary statistics:
| 5% |
25% |
50% |
75% |
95% |
| 0.519 |
0.763 |
1.000 |
1.380 |
2.344 |
In other words, 95% of the time, the spread on NSE for a $1 million rupee-dollar futures transaction was below 2.344 paisa. The median spread, for a $1 million transaction, was 1 paisa. This spread dropped below 0.5 paisa with only a 5% probability.
These numbers are significantly superior to those found on the OTC forward market, where, as a thumb rule, dealers feel that a $1 million transaction typically involves a spread of 2 paisa. This suggests that the liquidity at NSE is roughly 2x superior to the OTC market. The superiority of the execution at NSE is likely to be greater than 2x when we consider the opacity and execution risk of the OTC market. To the extent that order flow has shifted away from the forward market to the futures market, there could be a dynamic story here of the futures spread getting tighter at the expense of the forward spread.
This situation is unexpected. In the international experience, the currency forward markets is more liquid than its exchange-traded counterpart. This is despite the fact that futures markets has desirable features including near-zero counterparty risk, transparency, contracts standardisation and open public participation. The key reason for the domination of the OTC market appears to be historical. The OTC market came first, had entrenched liquidity, and the network externalities of liquidity hold the users in place.
In thinking about India’s currency futures market, it would be useful to compare and contrast with Brazil’s experience. Brazil is an interesting peer to India for reasons of a large GDP, democracy, rule of law, institutional quality, etc. It is also the only country of the world, prior to India, where the currency futures market became more liquid than the currency forward market.
In Brazil, currency futures trading began in 1991 – a seventeen year head start when compared with India. While Brazilian macroeconomics is now remarkably healthy, Brazil has had a turbulent history with many crises, high and volatile interest rates and inflation. The futures market, with daily marking to market, and therefore lower collateral requirements, offered a cheaper way to take positions in the currency. Nevertheless, there is reason to believe that several (sometimes unrelated) regulations contributed to tipping the balance in favor of futures contracts, so much so that today there is essentially no OTC market to speak of. The dealers on the forward market now provide OTC contracts to their customers but unwind their positions in the futures market (See Note 2). The regulatory pressures which moved liquidity from the OTC market to the futures market were:
- Access to spot markets was limited for several decades as a tool to control capital flight. Both domestic and foreign residents had easier access to futures markets than to spot markets. This led to greater number of players, and more liquidity in futures markets. Access to spot markets in Brazil is still far from free, for both domestic and foreign residents. India is in the same boat, with a futures market that is accessible to citizens but a spot market which is not.
- Until 2005, banks were subject to unremunerated reserve requirements on foreign exchange exposures exceeding pre-specified limits. These reserve ratios did not apply to futures positions, thus driving trading to futures markets.
- Until December 2007, Brazil imposed a financial transactions tax, called CPMF, on all debits on bank accounts. This levy applied to profit and loss payments on exchange traded contracts, not to their notional amounts, thus pushing activity to exchanges.
- OTC derivatives contracts are not netted, whereas contracts with the exchange or clearing house are netted by the latter. This means that the tax on cash flows, PIS-COFINS (See Note 3), de-facto taxes OTC transactions at a higher rate than exchange traded derivatives.
- Brazil has reporting requirements for OTC transactions – all transactions with domestic counterparties must be reported to regulators, in order for them to be considered enforceable. This levels the playing field in terms of the reporting burden of exchange traded versus OTC transactions. India has not yet done this.
- Pension funds are required to use only standardized derivatives contracts.
- The central bank, Banco Central Do Brasil, uses the futures market for doing currency intervention. This gives liquidity to the futures market, and also ensures that the OTC community has to look very carefully at the price on the screen so as to capture current information. India has not yet done this.
While some of these rules were removed in the 2000’s, after being in place for several years, their consequences have outlasted them. There is a path-dependence in market liquidity. These kinds of market rules matter in getting liquidity on the exchange off the ground. Once the exchange becomes liquid, the network externality of market liquidity sucks in further order flow and preserves the domination of the exchange even after these rules are removed.
Endnotes
1 The author is a senior analyst at the Bank of Canada. The views expressed here are personal. No responsibility for them should be attributed to the Bank of Canada.
2 The material in this note is a summary of information provided by Brazilian economists as well as that contained in Dodd and Griffith-Jones (2007), Brazil’s derivatives markets: hedging, central bank interevention and regulation, and Kolb and Overdahl (2006), Understanding futures markets, sixth edition, Blackwell Publishing.
3 The PIS and COFINS are federal taxes on revenues, charged on a monthly basis.
By Bron Suchecki, on October 20th, 2009
A reader has asked me to comment on these two recent GATA articles www.gata.org/node/7908 and www.gata.org/node/7911, which claim that London unallocated metal is a fractional reserve system.
Adrian Douglas’ assertion is that there is at a minimum four owners for each ounce of unallocated metal held in London. His support for this is to apply the ratio of average daily share trading in GLD (11.9m) to its shares outstanding (325m), rounding to a ratio of 1:30, to an estimate of the daily trading in gold in London to derive the amount of gold London should have. This is then compared to an estimate of what London does have, resulting in the 1:4 fractional ratio.
For his estimates of the London market, Douglas relies on a report by Paul Mylchreest. I haven’t had time to review Mylchreest’s numbers in detail, but his report takes a very logical approach and is fact based to estimating of the amount of gold in London. His conclusion is that there is
“an aggregate pool of gold of just over 16,866 tonnes of gold to support an average of 2,134 tonnes of daily spot gold trade. On this basis, 12.7% of the pool of available gold is being turned over every day on average. … And the entire pool is turned over every 7.9 working days. In my opinion, this level of trade relative to the estimated pool of gold liquidity is excessive and doesn’t pass the smell test.”
Firstly, he makes a series of assumptions to get to his figures. For example, his 16,866t figure relies on World Gold Council/industry estimates of above ground gold and the percentage that is investment. Being a trade organisation representing miners who want a high gold price one should expect that “stock” numbers will be estimated on the downside. When estimating what the real trading volume of gold is, then he steps into a more rubbery area because he is relying on only two guesses from some industry people – we need more than that.
As a result, one must consider his 12.7% turnover figure to have a fair margin of error considering all the assumptions and estimations used to derive it. This is not to say that it should be 1%, just that it is not a “hard” number.
Secondly, even if 12.7% is correct, I don’t think it logically follows that this “doesn’t pass the smell test”, a conclusion he comes to by comparing gold to equity, other commodities and fiat currencies. The last one is probably the most relevant. In this he has to again make some assumptions about currency trading turnover to come to a figure of 2.6% for Sterling, conceding that when including forwards and swaps “daily Sterling turnover is only equivalent to 8.4% of UK broad money”.
Why stop at Sterling? If one does the same calculations for the Australian dollar, you get 4.1% for spot and 13.3% including forwards and swaps. Does gold’s 12.7% (which could be lower if some of Mylchreest’s assumptions are changed) now appear as an “excessive amount of gold trading relative to the likely pool of available gold”?
Mylchreest’s final conclusion is that either 1. there is “more than one ownership claim on each gold bar” or 2. “there is far more gold bullion held in private hands than is acknowledged by current industry estimates”.
I would suggest that there is another OR that Mylchreest has not considered: the very fact that gold is no one’s liability and cannot be printed means it attracts a disproportionate amount of trading and speculation. Why is it assumed that 12.7% is excessive and unreasonable? Could not the 12.7% figure be proof of the special monetary nature of gold, proof that it is the King of Currencies?
I have spent a bit of time on Mylchreest’s report because it is the key input into Adrian Douglas’ calculations. Before I move on to his numbers, I would like to say that I have a lot of respect for Mylchreest’s report and look forward to it being improved with more accurate data.
On that, I note Mylchreest’s statement on page 25 that “I haven’t a clue what COMEX inventories were in 1997, but let’s assume 200 tonnes …” That information is available at Sharelynx.com going back to 1975. A subscription is required but would be worthwhile as Sharelynx has a lot of other data that would be very useful for Mylchreest’s analysis.
Now on to Adrian Douglas’ calculations. He is basically applying GLD’s turnover of 3.66% to Mylchreest’s turnover figure of 2,134t to come to an implied stock holding that London should have of 64,000t. This is then contrasted to Mylchreest’s estimate of 15,000t of non-leased physical to derive the 1:4 fractional ratio.
This analysis assumes that the behaviour of over-the-counter (OTC) players is/must be the same as those trading GLD. Let us consider each of Douglas’ statements in support of this.
“The purpose of buying investment gold is for it to store wealth. This necessarily implies that it is held for a long time.”
This is a very broad statement and one that I don’t think can be supported. Investors have all sorts of different time horizons. Remember we are talking about trading in unallocated and whether that is backed. The fact that it is unallocated rather than allocated bars would imply, if anything, that the investors have shorter time frames rather than long.
“If gold is bought and traded quickly it would destroy wealth, not store it, because there would be a large loss due to transactional fees.”
It is actually the other way around. The quicker you can trade something the less risk you have to changes in prices. Bullion banks have a spread between their bid and ask prices – they MAKE money from quickly trading gold. For those dealing with bullion banks in the OTC market, the tightness of those spreads combined with the volatility of gold mean it is entire reasonable for them to make money day trading gold.
“Considering these limitations [minimum trade limit of 1,000 ounces] it is likely that OTC participants would turn over a lot less than 1/30th of the inventory in a day.”
I do not see how the $1 million trade size must mean a lower turnover. That is not a big figure for wholesale market participants. With bullion bank spreads of $0.50 to $1.00, a 1000oz deal only means $500 to $1000 profit. This would mean that a spot gold trader would need to do a lot of trading to make a decent return on the capital employed, which means they would trade more frequently, rather than less.
As with Mylchreest’s comparisions to currency trading, I don’t think Douglas’ comparisions to GLD make any conclusive case that London gold turnover is suspicious.
For further support, Douglas notes that
“In the last 14 years the supply of dollars has increased from $4 trillion to $15 trillion (+275 percent) while the gold price has risen from $400 in 1995 to $1,000 in 2009 (+150 percent). How could this happen? … There has to be an alternative massive supply of gold to make the price rise slower than the influx of dollars.”
How it could happen is that those extra dollars were diverted into equities and house prices, rather than gold, pushing up their price more instead.
He also says that “If the OTC market traded only gold that was in the vaults on a 100 percent reserve ratio, there could never be a lack of liquidity.”
Lack of liquidity has nothing to do with stocks, backed or not. It has to do with a depth of buyers and sellers. If you have 100% backed unallocated, but few of the holders want to sell, then you have a lack of liquidity as well.
For some closing comments, I’ll quote Lawrence Williams from Mineweb:
“The big problem, though, with much of this kind of analysis is that the analysts and observers are working with a mixture of real and assumed figures. It thus tends to rely on statistics being manipulated, perhaps subconsciously, to support pre-conceived theories.” 
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