What finance can learn from automakers

Arnold Kling is appalled by Lynn Stout, who accuses Wall Street of providing too much liquidity:

Wall Street is providing far more liquidity (at a hefty price—remember that half-trillion-dollar payroll) than investors really need. Most of the money invested in stocks, bonds, and other securities comes from individuals who are saving for retirement, either by investing directly or through pension and mutual funds. These long-term investors don’t really need much liquidity, and they certainly don’t need a market where 165 percent of shares are bought and sold every year. They could get by with much less trading—and in fact, they did get by, quite happily. In 1976, when the transactions costs associated with buying and selling securities were much higher, fewer than 20 percent of equity shares changed hands every year. Yet no one was complaining in 1976 about any supposed lack of liquidity. Today we have nearly 10 times more trading, without any apparent benefit for anyone (other than Wall Street bankers and traders) from all that “liquidity.”

Kling disagrees, saying that liquidity is a good thing:

I have said that as individuals and nonfinancial firms we wish to hold liquid, riskless assets and issue risky, illiquid liabilities. Financial firms do the opposite. I am quite sure that this produces real benefits.

I'm going to walk the line between Kling and Stout in an effort to show how they're both right; liquidity is an awesome product that Wall Street just happens to be providing too much of. And I'm going to use the market for cars as my foil.

Given a choice between buying a car that has an old-fashioned manual transmission or a modern automatic, the easier option beckons. That's probably why automatics have become so popular with consumers since being introduced back in the 1940s. But the advent of the automatic transmission hasn't stopped automakers from selling vehicles with manual transmissions and consumers from buying them. If you're willing to put up with the constant pumping of the clutch in rush hour traffic, the smaller sticker price of a manual is quite attractive, as are its lower maintenance costs. By selling cars with either transmission, car companies satisfy the preferences of both sets of consumers.

This same strategy of product splitting (for lack of a better term) should also be used for liquidity, but it isn't.

When Wall Street improves the range of liquidity services that are built-in to bonds and shares, it does so for every instrument in existence. This sort of broad improvement in liquidity is what Kling is celebrating in his post. Now there should be no doubt that liquidity is a product that offers very real benefits, as Kling points out. But improving the liquidity of every instrument is like a car manufacturer adding only automatic transmissions to every car it produces. If you think that neither the ease of an automatic transmission nor the improved liquidity services embedded in a stock are justified by their higher price—tough luck: you can't exercise an opt out clause. You've simply got to eat the cost of these features.

While car manufacturers have chosen to appeal to both sets of customers by continuing to sell manual transmissions, Wall Street doesn't provide an equivalent liquidity-lite option to go with its regular fare of increasingly-liquid instruments. If you're a buy-and-hold investor like me, then you've probably purchased a few ETFs that you're going to unthinkingly hold for a x decades until retirement. Folks like us—slow investors—simply don't put much value on the ability to sell our ETFs at lightning speeds between now and then. So in a sense Stout is right to accuse bank executives of profiting from the overproduction of liquidity. Slow investors like me would be quite content with a good ol' manual transmission, but because Wall Street is only hawking fancy automatics, we're paying up for a product—liquidity—that we simply don't need.

And that's why I agree with both Kling and Stout. Kling is surely right that the huge quantity of liquidity created by Wall Street over the last 40 years has been a boon for many investors, but Stout is right that these liquidity services exceed the needs of a certain set of investors. Automatics are great, but unfortunately they're all that the finance industry builds—some of us just want manuals.

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If you're interested, here's a solution.

The way to satisfy both sets of investors, those who crave liquidity and those who don't, is for Wall Street to start engaging in the same product splitting that car manufacturers do. For every existing stock or ETF, offer both automatics & manuals: an expensive liquid option as well as an illiquid but cheaper version. As an example, consider that banks already offer manuals & automatics in their deposit businesses. Depositors can choose to hold easily transferable demand deposits or forgo liquidity by investing in higher-yielding (i.e. cheaper) term deposits.

Here are ways to implement a manual & automatic program in the world of equities:

1. Publicly-traded companies should start slow share programs.

By implementing a slow share program, companies provide those investor who are willing to forego liquidity for at least two years with bonus stock dividends. The shares of these investors are locked up; they cannot be sold. Short term investors, those who prefer to hold for less than two years—and therefore refuse to lock up their shares—won't qualify for the bonus. Stock dividends provided by a slow share program improve the returns of long-term investors by diluting the ownership position of short-term investors. To complete our car analogy, locked-in slow shares are Wall Street's cheap but inconvenient manual transmission; regular unlocked shares are the expensive but handy automatic.

I go into some of the reasons that firms may have for rewarding long term investors here.

2. Financial services firms should provide equity deposits.

When an investor buys an ETF or an index mutual fund, it's as if they've deposited the underlying shares at a bank and have received a receipt in return. The receipt for the world's most popular ETF, the SPDR S&P 500, is incredibly liquid; as long as it's not the weekend or late at night, anyone can cash out in just a moment. An index mutual fund receipt is a little less liquid; it can only be redeemed at the end of each trading day.

If ETFs and index mutual funds are the expensive automatics of the finance world, here's how to create a cheap manual. The idea behind an equity deposit is to push the redemption period out even longer. A three-month equity deposit could only be cashed in after three months have expired, a five-year deposit after five years have passed, and likewise for a twenty-year deposit.

Because the manager of an equity deposit scheme has a set of investors who have committed to being illiquid for a fixed term, he/she can lock up more shares in slow share programs than the manager of an ETF or index mutual fund, who always requires a certain degree of flexibility to meet the liquidity needs of investors. Greater participation in slow share programs means that the returns that flow to an equity deposit holder will always be higher than those that flow to ETF or index mutual fund owner, or, put differently, that those willing to forgo liquidity can buy a dollar's worth of corporate earnings for less than those who are not willing to forgo it.

While slow share schemes are just science fiction, stock lending provides a real life way for equity deposit managers to reduce costs. ETFs and index funds earn significant amounts from lending out stock, see for instance here. Because they have a committed deposit base, equity deposit managers would be able to commit to lending out stock for long periods of time, say for a fixed 365-day term. Because their base of depositors can cash out at any moment, ETF and index fund managers can only rollover a series of 1-day stock loans for 365 days. This flexibility allows equity deposit managers to harvest the stock lending term premium. Put differently, you can make a lot more money by committing to lend once for a full year than to lend 365 times for one day.

I've gone into more detail on equity deposits, the potential manual transmission of the finance world, here and here.

The social function of equity deposits

One more post on equity deposits.

My last post described a dirt cheap (and hypothetical) way for long-term investors to get exposure to equities. Briefly, an investor commits a certain amount of money to a one-year term deposit that promises an equity index-linked return. The manager of this equity deposit (ED) invests that money in an appropriate number of shares in the companies that make up the index, then lends these shares out to borrowers for one year at a fixed rate. At the end of the year the stocks on loan are recalled, sold, and the investor's deposit is repaid. The interest earned on stock loans is shared with the depositor, boosting their returns.

It's worth pointing out that ETFs already lend out shares, but unlike an ED they can only do so on an overnight basis. So an ETF can't harvest the extra term premium on long-term loans.

EDs have a broader social purpose than just saving a few bucks. Here's a quick list:

1. Equity deposits would reduce the dead weight loss currently being incurred by long-term investors.

The investing world currently discriminates against long-term investors by requiring them to invest in securities that are tailor-made for short-term traders. Stocks, ETFs, and mutual funds enjoy a permanent trading window--the ability to cash out of the stock market in a millisecond. Long-term investors who have precommitted to the stock market for ten or twenty years simply don't need this feature. Unfortunately, not only do they not have a choice (all securities have these windows), but they must pay the fees involved in the maintenance of said window. This is an an efficient allocation of resources, or what economists call a dead weight loss.

Equity deposits are tailor-made for the long-term investor. By removing the trading window, long-term investors no longer have to pay for a feature that caters to traders, thus lowering investors' costs and improving their returns. The world is made more efficient.

2. Borrowers of stock are missing a market. Equity deposits would fill this gap.

Anyone who wants to borrow dollars from a bank can do so overnight or on a long-term basis. It's not the same when it comes to other financial instruments. Anyone who wants to borrow stock can only do so overnight. An equity deposit provides the missing market.

The reason for this gap is that institutional owners of stock like ETFs and mutual funds face the possibility that they might be besieged at any moment by redemption requests. This means that they can only lend out stock on a short term basis to borrowers, usually overnight. Because owners of equity deposits have committed to a fixed holding period, the manager of an ED is free to lend underlying stock out on a long-term fixed rate basis. Borrowers should be willing to pay an ED manager a premium rate of interest for the certainty its fixed products provide.

Which leads into points 3, 4, and 5...

3. Equity deposits would improve market liquidity and reduce price volatility.

The job of a market maker is to facilitate trading in a security by maintaining tight spreads between the bid and ask price. Market makers need an inventory of securities to do their job, and they will often borrow to ensure that supply. Because most shares are lent out on an overnight basis, this source of liquidity is flighty. Stock can be recalled without warning and lending rates can get ratcheted up suddenly. A manager of an ED can offer market makers a guaranteed supply at a fixed price, thus reducing the uncertainty involved in market making. Hopefully this will help make for a thicker and tighter market.

4. Equity deposits would improve price discovery.

Arbitrageurs need to borrow stock to put on the short leg of their strategies. Because most equity loans can be recalled at any moment and lending rates can change daily, it can be difficult to know ahead of time the return of a certain strategy. Equity deposits provide a stable long-term supply of stock for arbitrageurs at a fixed lending rate, thus helping to ensure that the arbitrage process keeps prices in line.

5. Equity deposits provide a useful risk management tool.

Hedgers may need to borrow stock and sell it to hedge some other position they hold, thus offsetting risk. Long-term fixed interest rate loans may offer the hedger more peace of mind than a series of overnight loans that might be reset at higher interest rates without warning.

In closing, ETFs and index mutual funds have become more than just vehicles for retail investors to get passive market exposure. They have also become intermediaries between overnight lenders and borrowers of stock, even if most retail investors in ETFs do not actually realize that they have become lenders. An equity deposit mimics the passive market exposure provided by an ETF while extending the lending business from an overnight basis to what should be a more profitable long-term basis.

It is generally accepted that stock lending brings stability to the marketplace. But as we know from the financial crisis, overnight markets are run-prone. Long-term stock lending via an ED solves the run problem; it seems like an incremental way to create a more robust system.

Even cheaper than an ETF

John Bogle, father of passive investing

With fees as low as 0.10%, passively managed ETFs are one of the cheapest ways to get exposure to equities. Not bad, but here's a financial product that would be even cheaper for investors: an equity deposit. I figure that equity deposits would be so cost efficient that rather than charging a management fee, investors would be paid to own them.

To understand how equity deposits would work, I want to make an analogy to bank deposits. Think of an equity ETF as a chequing account and an equity deposit, or ED, as a term deposit. In the same way that chequing deposits can be offloaded on demand, an ETF can be sold whenever the owner wants, say on the New York Stock Exchange or NASDAQ. Equity deposits, like term deposits, would be locked in until their term was up up. Issued in 1-month, 3-month, 1-year, 3-year, and 5-year terms, EDs would replicate a popular equity index like the S&P 500.

Given that both ETFs and EDs track the same index, and both provide the same dividends, the sole difference between the ETF and the ED is their liquidity. A commitment by an investor to an ED is irrevocable (at least until the term is up) whereas an ETF allows one to change one's mind.  ETFs represent liquid equity exposure; EDs are illiquid equity exposure.

An investor might buy an ED rather than an ETF for the same reason that they might prefer term deposits to a chequing account; they are willing to sacrifice liquidity for a yield. For a trader with a holding period of a few minutes or hours, an ED would be an atrocious instrument. On the other end of the spectrum, long-term buy-and-hold investor would be perfect candidates for substitution from ETFs into EDs. Come hell or high water, investors following a buy and hold strategy have pre-committed themselves to owning equities till they retire. As such, they don't need the permanent liquidity window that ETFs provide. Now if that window were provided free of charge, then investors may as well buy ETFs. But liquidity doesn't come without a cost, as I'll show below. Which means that long-term investors who own ETFs are paying for a worthless feature.

Better for a buy and hold investor to slide a portion of the portfolio that has already been dedicated to ETFs into higher yielding 5-year EDs, rolling these over four or five times until they retire. In doing so, investors get a higher return while forfeiting liquidity, a property they put no value on anyways.

How is it that an ED can provide a higher return than an ETF? Here's how. Once investors' funds have been irrevocably deposited into a 5-year vehicle, the manager buys the stocks underlying the S&P 500. Next, the manager offers to lend this stock to various market participants, either short sellers looking to make a quick buck or market makers who want to replenish inventories. These loans, which are quite safe due to the fact that the borrower provides collateral, earn a recurring stream of interest income which the ED manager shares with the ED investor. This return should be high enough to more-than counterbalance management expenses such that on net, ED investors end up earning an extra 0.25% or so each year rather than paying 0.10-0.50%.

But wait a minute, why don't ETFs do the same thing? Why don't they lend stock and share the income with ETF investors? Actually, they already do. And in some cases, ETF managers are already providing investors with more in lending income than they are docking them to manage the ETF. See the screenshot below from an iShares quarterly report:

The iShares Russell 2000 ETF, which has a net asset value of around $25 billion, provided investors with $34.58 million in stock lending income in the six months ended September 30, 2015, well in excess of advisory fees of $27.85 million.

So yes, ETFs can and do earn stock lending income, but my claim is that an ED manager following an equivalent index would be able to earn even more from lending out stock. To understand why, we need to think about how stock lending works. Stock loans are usually callable, meaning that the lender, in this case the ETF, can ask for a return of lent stock whenever they want. Callability is terribly disadvantageous to the borrower, especially a short seller, as they may have to buy back and return  said stock when they least want to, say during a short squeeze. In order to protect themselves, a short seller will always prefer a non-callable stock loan, say for 1-year, then a callable one, and will be willing to pay a higher interest rate to enjoy that protection.

ETFs and mutual funds are not in the position to provide non-callable stock loans because ETF and mutual fund units can be redeemed on demand by investors. For instance, if performance lags a mutual fund manager may start to experience large redemption requests. To meet those demands, the manager needs the flexibility to recall lent stock and quickly sell it. As for ETFs, units can be redeemed when authorized participants submit them to the ETF manager in return for underlying stock. So an ETF manager is limited in their ability to lend out stock on a long term basis lest they are unable to fulfill requests from authorized participants. Because ETFs and mutual funds can only lend on a callable/short-term basis they must content themselves with a correspondingly low return on lent stock.

As one of the only actors in the equity ecosystem with a long-term pool of pre-committed stock-denominated capital, an ED manager is in the unique position of being able to make non-callable term stock loans. Put differently, redemption of EDs is distant and certain, so only an ED structure allows for the perfect matching of long term assets with long-term liabilities. This means EDs should enjoy superior stock lending revenues, more than offsetting the costs of running the ED.

Say that an ED can beat an ETF by around 0.5% a year thanks to its superior stock lending returns. That doesn't sound like much, but compounded over a long period of time it grows into a large chunk. For instance,  If you invest $2000 each year for 25 years in an ETF that earns 8%, you end up with $157,900. Place those funds in an ED that returns 8.5% and you end up with $170,700. That's a pretty big difference.

EDs don't exist. But if they did I'd probably sell a significant number of my ETFs and buy EDs. I could imagine putting 20% of my savings in a 5-year S&P 500 ED, for instance. What about you?

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PS: Feel free to torture test this idea in the comments
PPS: It is very possible that this product already exists.
PPPS: The devil is in the legal details.

Related posts:

An ode to illiquid stocks for the retail investor 
A description of the moneyness market 
If your favorite holding period is forever 
Beyond Buffett: Liquidity-adjusted equity valuation 
Liquidity as static 
No eureka moment when it comes to measuring liquidity