Why the ‘real economy’ needs efficient markets

17 November 2014


For those of us with a professional involvement in the financial markets, it’s easy to lose sight of the wood for the trees: we’re so buried in the complexity of how markets function that we often forget to explain the big picture.  Worse, even:  the language we find necessary to explain our complex system among ourselves is almost impenetrable from the outside.

This is of course a collective failure. A lack of understanding of how  the  markets impact on everyday life is, in my view, one of many reasons the ‘City’ is currently held in such low regard in popular culture. The shame is that we have a good story to tell.

Painting the big picture is also a necessary first step to explaining the detail.  Without understanding the social utility, people won’t understand why so much effort is put into ensuring that our markets run as smoothly and efficiently as possible.

In effect, no individual or company lends or borrows money without it going through the financial markets: every time you put money in your bank or pension fund you are lending it to them to invest in the markets, and every time you borrow money in a mortgage or short term loan, it may be funded by transactions in the financial markets. 

The markets are made up of:

  • banks managing the risk of facilitating money transfer, including individual savings accounts, SME loans and home mortgages (as above),
  • employee pension schemes and private pension funds, which are gathering and investing major capital,
  • individual investors day trading or portfolio building, and
  • companies of all sizes, raising funds to grow and managing risk.

These participants have different interests (off-setting risk, growing capital, raising funds) and therefore different trading strategies and timescales. For example, pension funds invest the funds managed for each individual and then hedges the portfolio, both through the markets, which has a long term timeframe (potentially years), while EU import/export companies need to hedge their currency exposure on their transactions overseas, which has a medium term timeframe (likely to be weeks). This means that their interests in particular assets at any particular time may differ. 

At their best, markets create long term, sustainable value to society through the allocation of capital where and when it is needed, like banks extending credit to high street borrowers. To do this efficiently, buyers and sellers, borrowers and lenders have to be matched, and a balance found between short-term and long-term views: intermediaries are key to achieving this. Market makers transform assets by making matches between investors and depositors looking for shorter-term investments, and firms with opportunities for higher potential returns. Market-makers also facilitate transactions by banks and credit institutions that hold and manage assets, such as retirement income, on behalf of others, whether individuals, companies or governments, to hedge and transfer risk. By enabling these institutions to trade rapidly, end investors are protected from risks, and their costs are reduced.

As an example: a key element of mortgage providers being able to offer the lowest possible rates to home owners is their ability to manage risk.  An important element of this is ‘hedging’ against risks to their portfolio, such as interest rate changes. The more efficiently a mortgage lender can access the markets to hedge against their risks, the lower the rates they will be able to pass on to customers.
Another cost reduction created by well-functioning markets is that of agency costs. The rise of electronic (aka low touch trading) has meant investors need less and less hand holding from brokers and their traders, which continues to reduce agency costs, from which end investors should immediately benefit. Algo trading firms have been key to automating the dissemination of market data, to make information readily accessible to all investors in real time, not just agencies.

For the markets to create value sustainably, they have to be able to identify hidden risks. With efficient markets, companies cannot offload their hidden costs onto society, while making private gains. In efficient markets, pricing information between related assets can be aligned, so a change in one can be reflected in the market prices of its related assets as quickly as possible. A simple example of this is that a change in the price of coffee as a commodity will have an impact on the share prices of companies who are heavy users of that commodity (Starbucks, Costa, Nero, etc.): in efficient, connected markets, this change will be reflected immediately in the prices of the dependent companies’ shares. When markets are inefficient, and not well connected, the prices may not be re-aligned automatically, leading to inefficiencies and pricing discrepancies.

The views expressed in this blog post are the personal opinions of the author and do not necessarily reflect the official policies or positions of the FIA European Principal Traders Association or the Futures Industry Association.

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