The storms that have hammered the equity markets in recent weeks were brought on by an overvalued market, foreboding international news, cascading investor emotions, and insufficient liquidity. Which of these should we focus on to temper any repeat in the future? The answer is clear: Liquidity, because it is directly controllable.
Liquidity is to a market as oil is to machinery – a necessity. Ironically, financial markets, which provide liquidity to firms throughout the economy, are themselves hurt by insufficient provision of this essential oil. And when liquidity dries up, volatility ensues.
Equity investors and traders, along with regulators in the U.S. and Europe, are acutely concerned about our equity markets suffering from insufficient liquidity.
Where can more liquidity be found?
Kick it up to corporate.
Let me explain. In an equity market, liquidity comes from the limit orders placed by public customers (including high frequency traders), and by quotes posted by dealers. But these agents do not supply adequate liquidity, not for mid and small-cap stocks. And not for an institutional investor who trades in multiples of 50,000 shares.
Consequently, intra-day price volatility is higher, and flash crashes occur.
The NYSE and London Stock Exchange, recognizing the illiquidity problem, plan to introduce special noon auctions to enhance liquidity at a time when trading is particularly sparse, especially for low-cap stocks.
But this isn’t enough. We should turn to a totally different entity. We should bring in the corporations themselves.
It’s been done before. On October 19, 1987, just as certain calamitous events were roiling the markets — budget and trade deficits, rising interest rates and inflation, unrest in the Middle East — sell orders thundered in, liquidity on the buyside evaporated, and stock prices plunged.
To stem a further decline, NYSE CEO John Phelan recognized that listed companies could provide liquidity for their own shares. In response to his calls, nearly 600 firms announced open-market repurchase programs. It worked: The market stabilized.
Phelan’s bold thinking wasn’t unprecedented. In 1934, Benjamin Graham and David Dodd addressed this very point in their classic book, “Security Analysis”:
It follows that the responsibility of managements to act in the interest of their shareholders includes the obligation to prevent — insofar as they are able — the establishment of either absurdly high or unduly low prices for their securities.
Regulators, however, are looking for other ways to stabilize the markets. They’ve proposed imposing a special fee on trading, requiring that unexecuted orders remain posted for a minimum resting time, and attracting a larger provision of market maker capital. Such tinkering with the operations of traders and dealers will not work. We shouldn’t interfere in this way with the workings of a free market.
I suggest a better alternative: The listed companies should be the source of the additional liquidity needed to achieve more orderly price determination for their shares.
While a listed company may not believe in playing a market-maker role — an automaker’s business is producing cars, not making the market for its own stock — drawing from what Phelan did in the 1980s, from what Graham and Dodd stressed in the 1930s, and my own work with several co-authors, I suggest that a listed company is well positioned to augment liquidity for its shares.
A company — seeking to maximize the value of its shares — can better internalize the benefits attributable to deeper liquidity provision and enhanced price discovery. Thus I call for the following measures:
– Establishment of corporate liquidity funds to buy back the company’s stock in a falling market, and to sell its shares in a rising market.
– The funds should be managed by third-party fiduciaries who will act in an advisory capacity and guard against market manipulation. The procedure must be totally transparent, with all parameters announced in advance.
– Corporate orders should be entered in an exchange’s call auctions only; by pooling orders for execution at a single price, auctions amass liquidity and sharpen price discovery. In an auction, the corporate orders will neither peg nor fix price, but will simply be another input into the determination of the clearing price.
The listed companies want their shares priced higher. Participants want stocks priced more accurately. The broad market will benefit: market prices are used to mark positions to market, for derivative trading, for estate valuations, and for mutual fund valuations. Corporations themselves employ them to assess their costs of capital.
But as long as liquidity remains inadequate, unduly high short-run bouts of volatility will continue to rile the market, and investors who are turned off by the presumption that the markets are too chaotic and unfair will simply back away.
Robert A. Schwartz is the Marvin M. Speiser Professor of Finance and University Distinguished Professor of Finance at the Zicklin School of Business at Baruch College. He is the recipient of the first World Federation of Exchanges’ Award for Excellence.
