The EconomistNovember 9th 2019 Finance & economics 612
Buttonwood Against the flow
I
magine twobonds listed on different
exchanges that are otherwise identical.
The risk-free rate of return is 2%. In-
vestors hold bonds for an average of one
year. A central bank acts as market-
maker, supplying cash on demand for
bonds. To cover its costs, the price the
central bank pays (the bid) is a bit below
the fair value of a bond, which is the price
it requires buyers to pay for it (the ask).
The bid-ask spread is the cost of trading.
For a-bonds it is 1%. For b-bonds, which
are listed on an inefficient exchange that
charges higher fees, it is 4%.
What is the yield on each bond? It
varies with trading costs. Investors on
average make one round-trip sale-and-
purchase a year. So the yield they de-
mand on a-bonds is 3%. That includes
the risk-free rate of 2% plus 1% compen-
sation for trading costs. By the same
logic, the yield on b-bonds is 6%. The
extra 3% return required on the harder-
to-trade security is known as the illiquid-
ity premium.
Illiquidity matters less if investors
have longer horizons. A pioneering paper
by Yakov Amihud and Haim Mendelson,
published in 1986, posits that investors
with the shortest horizons hold securi-
ties with the lowest trading costs; and
bonds that are relatively illiquid are held
by long-term investors, who can spread
the higher trading costs over a longer
holding period. In principle patient
investors can reap a reward from illi-
quidity. But in practice the risks that go
with it often prove to be bigger than
many investors had expected.
In our simple example, fees are the
friction that makes one security costlier
to trade than another. But there are other
features intrinsic to the securities them-
selves that make them more or less liq-
uid. The shares of big companies, such asApple or ExxonMobil, are traded cheaply
in seconds, because they are part of a big
pool of identical securities. Buy and sell
orders can be effortlessly matched on
electronic order books. In contrast, a
company may have bonds of several matu-
rities. So corporate bonds are intrinsically
less liquid than stocks.
In markets for very specialised assets,
finding a suitable buyer or seller is costly.
A wider bid-ask spread is needed to com-
pensate for these search costs as well as for
the risk of prices moving in the meantime.
It also takes costly effort and skill to ap-
praise the value of idiosyncratic assets.
There is a greater chance that your coun-
terparty knows more about the asset’s true
value than you do; so you may end up
buying a lemon or selling a hidden gem.
Such risks add to the cost of trading less
liquid assets and to the illiquidity pre-
mium that investors require to hold them.
Most assets are somewhat illiquid.
Houses can take several months to sell. A
piece of fine art might not trade for de-
cades. Some kinds of investments, such as
limited partnerships in private-equity orventure-capital funds, require capital to
be locked up for several years. Second-
ary-market trades are rare; where they
occur, they are at predatory discounts.
The liquidity cost of holding such thinly
traded assets cannot usefully be repre-
sented by a bid-ask spread. It is more
helpful to think of lockup as incurring an
opportunity cost. Liquidity affords op-
tions; and illiquidity constrains them.
An illiquid asset cannot easily be sold to
meet unexpected spending needs (say,
medical expenses) or to take advantage
of better investment opportunities.
Liquidity varies over as time as well as
between assets. It relies on the capacity
of private-sector traders and arbitrageurs
to supply it. That varies. In good times, it
is abundant. Asset prices are on a gener-
ally rising trend so market-makers find it
easy to borrow to finance their stock of
securities. But in bad times, trading
liquidity dries up. In extreme cases, such
as the 2008-09 financial crises, there are
self-perpetuating “liquidity spirals”:
market-makers take losses on their
stockholdings; they are forced to sell
assets to preserve their cashflow; and
that in turn drives prices lower, further
impairing their ability to trade securities.
At such times a lot of investors who
were intent on picking up an illiquidity
premium discover that they are far less
patient than they had believed them-
selves to be back when liquidity was
plentiful. The possession of cash or the
ability to raise it quickly is especially
valuable in recessions. The skilful are
able to pick up assets cheaply that others
have been forced to sell. A short-horizon
investor won’t buy such assets, for they
might become even cheaper. But a truly
patient investor who can wait for the
payoff is able to step in—as long, of
course, as he is liquid.More and more investors are chasing the illiquidity premium. But what exactly is it?risen much faster than global gdp. Still,
most of the world’s billionaire wealth has
been earned fair and square. Oprah Win-
frey, for instance, has a fortune of about
$3bn. It is one thing to feel that having so
much money is distasteful. It is quite an-
other to argue that these people have accu-
mulated their wealth illegitimately and
should be stripped of it.
But some billionaires are less upstand-
ing, indulging in what economists call
“rent-seeking”. This takes place when the
owners of an input of production—labour,
machines, intellectual property, capital—extract more profit than they would get in a
competitive market. Such activity may or
may not be illegal, and often involves car-
tels and lobbying for rules that benefit a
firm at the expense of competitors and cus-
tomers. Our analysis identifies industries
where rent-seeking is common, including
mining, defence, construction and casi-
nos. This time it also includes the largest
tech companies, since many of them have
engaged in anticompetitive practices.
Three-quarters of billionaires’ wealth
in advanced economies was fairly ac-
quired. Still, rentier wealth has risen rela-tive to gdp. Some countries are more cro-
nyfied than others. Sweden and Germany
less so. But in America rent-seeking indus-
tries made one in five billionaires and ex-
plain a third of total billionaire wealth.
What should be done? Governments
could do more to expose oligopolies to
competition. Another option would be
higher taxes on wealth transfers (according
to a separate analysis, one-third of global
billionaire wealth is inherited). Making the
economy more competitive would do more
for ordinary folk than tarring all plutocrats
with the same brush. 7