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.