2019-11-09_The_Economist

68 Finance & economics The EconomistNovember 9th 2019

2

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 as

Apple 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 or

venture-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