Sincerity - the subjective rationality of markets

The Vietnamese have a proverb: two women and a duck make a market. This simple saying highlights the inter-subjective nature of markets, there is an asset (the duck) who’s price is determined through the discussion of two subjects.

The foundation of this paper is in the claim that financial markets should be perceived as centres of communicative, as opposed to strategic, action. This claim rests on recognising a distinction between markets based on market-makers (in England, ‘jobbers’) and those based on brokers. A broker, whether an individual or a firm, makes their money by arranging transactions between buyers and sellers for a fee; brokers facilitate the strategic action of those who own property. Most commercial transactions, such as buying groceries, are facilitated by brokers, such as retail supermarkets; in the context of financial markets brokers mediate between ‘investors’. Brokers make a living from the commission they charge for bringing buyers and sellers together. Most general retailers look for a 100% commission (they charge buyers twice the price an item is sold for), auctioneers charge sellers and buyers commissions running 10%-20% each, estate agents charge 0.5%- 3%; commission rates fall as the value of the asset rises. While a broker’s commission rate is proportional to the liquidity of the asset, the absolute commission is lowest on the most liquid assets.

Market-makers, sometimes known as ‘dealers’ in the U.S.¹, will quote bid prices, at which they will buy an asset, and offer prices, at which they will sell an asset, without knowing if the counter-party is seeking to buy or sell the asset (though the quantity will affect the quoted prices). The market-maker makes a living through the bid-ask spread: the bid price is always lower than the offer. The bid-offer spread is highest when liquidity is low and and market-makers profit when investors are ill-informed and prices change frequently (Bagehot, 1971:13)², (Millo, 2003:89), (Carruthers and Stinchcombe, 1999:Note 14), leaving them open to the accusation that they promote uncertainty. The general public encounter market-makers in banking, where banks traditionally make money by lending to and borrowing from customers at differential rates. This final observation justifies the focus on market-making in the context of debt markets.

Stock-jobbing had a dubious reputation as the English financial markets emerged in the late seventeenth century. In 1719 Daniel Defoe wrote The Anatomy of Exchange Alley in which he described stock-jobbing as

a trade founded in fraud, born of deceit, and nourished by trick, cheat, wheedle, forgeries, falsehoods, and all sorts of delusions; coining false news, this way good, this way bad; whispering imaginary terrors, frights hopes, expectations, and then preying upon the weakness of those whose imaginations they have wrought upon (Poitras, 2000:290)

An observation mentioned by Defoe but more explicitly stated by Thomas Mortimer in 1761 concerned the type of person involved in stock-jobbing. Mortimer makes the point that there are three types of stock-jobber: foreigners; gentry, merchants and tradesmen; and “by far the greatest number”, people

with very little, and often, no property at all in the funds, who job in them on credit, and transact more business in several government securities in one hour, without having a shilling of property in any of them, than the real proprietors of thousand transact in several years. (Poitras, 2000:291)

These jobbers did not only trade in vanilla products such as stocks or bonds. Murphy (2009:24-30) estimates that around 40% of the trades between 1692 and 1695 were in stock options that were being traded in order to manage the risks of stock trading: ‘hedging’. Evidence of the widespread use of options comes in Colley Cibber’s 1720 play, The Refusal (the term for an option at the time) describing the action in Exchange Alley

There you’ll see a duke dangling after a director; here a peer and ‘prentice haggling for an eighth; there a Jew and a parson making up the differences; there a young woman of quality buying bears of a Quaker; and there an old one selling refusals to a lieutenant of grenadiers (Ackroyd, 2001:308)

The role of stock-jobbers in the U.K. markets became normalised and an accepted part of the financial system from the late eighteenth century until 1986 when they disappeared with the ‘Big Bang’ reforms. Attard (2000) reports that at the end of the nineteenth century the number of jobbers and brokers on the London Stock Exchange were approximately equal, though the proportion of jobbers increased at times when new markets emerged. Through the twentieth century the proportion of jobbers declined: in 1908, at the height of the market before the collapse of Bretton-Woods there were some 3,300 jobbers to 1,700 brokers; in 1938 there were 1,433 jobbers to 2,491 brokers; in 1961, 697 jobbers to 2,694 brokers. The majority of jobbers worked in small partnerships of one or two members but the most of the business passed through a few large firms, such as Akroyd & Smithers, who ‘made’ the market in British government debt.

Mackenzie and Millo (2001:19-22) present a similar picture of the market-makers of the Chicago exchanges as outsiders with limited reserves while (MacKenzie, 2008:142) describes how the Chicago market-makers were idle in the late 1960s and a comprehensive account of market-making culture at the Chicago Board of Trade is given in Millo (2003:88-132). This reveals that while a ‘designated market-maker’ is obliged to provide bid and offer quotes to a broker the majority of market-making activity is conducted by market-makers who risk their own capital as ‘traders’.

On this basis we can describe a market made by market-makers as a discursive arena. A market-maker will make an assertion as to the price of an asset by giving the market a bid and offer price. If other traders agree with the bid-offer, they let it pass and do nothing. If, however, another trader feels the market-maker has mis-priced the asset, they will act - challenging the assertion - by executing a trade. Note that the specification of a bid-offer pair by a market-maker is critical: offering to sell air for £1,000/kg would not demonstrate anything, offering to buy air at £999.95/kg would be challenged as a mis-pricing. It is through this process, whereby one market-maker makes a claim as to what is a true price and then the claim being challenged, that the market seeks to reach an understanding as to the price of an asset. The process is one where traders are continually taking yes-no positions to validity claims implicit in quotes. Central to this process is that the market-maker’s and dealer’s “manifest intention is meant as it is expressed” (Habermas, 1985:99) with the evidence being that they are prepared to act on their utterances by having ‘skin in the game’ (Taleb and Sandis, 2014).

In what followers we shall use the term ‘jobber’, as distinct from ‘broker’, to refer to an agent acting as a market-market, trader or arbitrageur³: that is they are concerned with asset pricing as distinct from asset valuation, which is the aim of investors. We can contrast the markets mediated by jobbers from the type of markets mediated by brokers, were commodity owners undertake exchange, by considering an extreme example of commodity exchange where a central authority sets the price, such as the Emperor Charlemagne who in the ninth century, at the start of feudalism, set the ‘just price’ of commodities that would apply in Bordeaux, Aachen, Salzburg or Lubeck. When Charlemagne set the price of a good throughout his empire he was setting the rate at which a commodity would settle a tax debt, rather than relating the price to supply and demand. This had the effect that merchants could not move a commodity from an area of abundance to region with a shortage, which would lead to a certain loss since prices were fixed. This is a central problem of economics and a focus of much economic theory is on the allocation of resources across a society. Neo-liberal economic theory has it that the ‘market’ will achieve an optimal distribution while Marxists argue that the institution of private property creates the scarcity and the consequential power-imbalances enable the bourgeois to exploit the proletariat.

The issue of the power of the price setter could be resolved by obliging the price setter to specify not just the price at which a commodity is brought (or sold) but by obliging them to offer both bid and offer prices. This is an obvious practical solution but it points to the central issue: if an authority is only giving a price at which he is willing to buy a commodity, but not at which he is willing to sell it, they is being insincere, in the sense that they are being hypocritical, about the price. By requiring authority to give both bid and offer prices their power to act arbitrarily is curtailed. Kaye (1998:22-25) describes how in France in the first decade of the fourteenth century, after a century of the society’s monetisation, the authority of Philip IV to set economic affairs was challenged by the broad public signalling the end of feudalism.

In a market mediated by jobbers, recorded prices represent, not an implicit agreement in the price quoted by the market-maker but, an explicit disagreement in the market-maker’s valuation. This is because a speculator would only trade with a market-maker if they believed they would profit at the price quoted and this would only be the case if the speculator believed the market-maker had mis-priced. The statement that market prices indicate disagreement appears incoherent with standard economic theory that argues the market price is the true price and is discussed in Bjerg (2014:24). Standard economic theory focuses on exchange undertaken by owners of commodities, in this case it is reasonable to believe that the two parties can come to some agreement as where the equivalence between commodities should rest. This type of exchange is dominated by objective rationality, discussed in the Reciprocity as a Foundationof Financial Economics.

We make sense of the apparent incoherence of jobber-mediated markets delivering prices that are disputed by noting that, unlike investors, jobbers have no commitment to the assets they trade. A jobber gives prices in much the same manner as a good book-maker - by setting prices that balance supply and demand and bringing to mind Ramsey (1931:181-183). Believing that there is an objective value of the asset they are trading can be detrimental. Market-makers should focus on the relative volume of buy and sell orders and traders make a subjective assessment as the veracity of the prices given by market-makers. This attitude is captured in Beunza and Stark (2012:394) where it is recorded that terms like buy and sell suggest a commitment to assets that traders see as a sign of un-professionalism. It was also understood by the Scholastics, who recognised that “the individual’s responsibility in economic activity is effectively eliminated” if finance rests solely on objective valuations (Kaye, 1998:98-99). The difference between broker and jobber mediated markets is emphasised by the difference between traditional ‘cash-and-carry’ markets, where it is possible to physically hold the asset and valuations can be regarded as objective, and ‘price discovery’ markets associated with financialisation and where the asset is intangible and so prices are subjective (Hirsa and Neftci, 2013:3).

Financialisation is often presented as a recent phenomenon, alongside neo-liberalism and globalisation (for example, Krippner (2005)), emerging after the collapse of the Bretton-Woods system of fixed exchange rates in 1971. However, finance - the science of money - has eclipsed commodity exchange at a number of times in the history of western Europe. Money appears in pre-Socratic Greece (Seaford, 2004); comes to dominate trade in the thirteenth century (Hadden, 1994; Kaye, 1998); and is a significant feature of seventeenth century England and the Netherlands. These episodes of financialisation are also associated with the democratisation of politics and the development of ‘western science’.

An example of seventeenth century financialisation, closely linked to globalisation at the time, is given by Poitras (2000:274-277) who describes the emergence of stock trading in seventeenth century Amsterdam. During this time the trade of ‘duction’ shares was reported in de la Vega’s Confusion de Confusiones⁴ (1688). Duction shares had a nominal value of one tenth a Dutch East India Company (VOC) share but there was no expectation that holding ten ductions would entitle someone to a VOC share: . Duction shares appeared because it was impossible for the general public to participate in speculation on VOC shares, which were held exclusively by the Dutch elite and their trading incurred significant transaction costs. Duction trading enabled the public to challenge the VOC owners’ assessment of the value of the firm and in 1610 the VOC board petitioned the government to prohibit the sale of shares “in blanco” (short-selling, signifying the public felt the VOC was over-valued). The ban was ineffective, and had to be repeated in 1624, 1630, 1636 and 1677. de Goede (2005) discusses the similar phenomenon of ‘bucket shops’ that appeared in the U.S. in the 1870s and enabled the American working class to speculate on commodity prices without having to incur the cost of trading through CBOT.

While many argue that modern (quantitative) finance starts with Bachelier’s thesis of 1900 (such as Bjerg (2014:19), Appadurai (2015:2-3), Roffe (2015:11)) we would argue that Bachelier’s work, and the subsequent, independent, work of Bronzin (Zimmermann and Hafner, 2007) that is much closer to current theory than Bachelier, marks the end of an era that had included the railway booms and the globalisation associated with nineteenth century colonisation. Between the closure of the exchanges at the start of the 1914-1918 War and the collapse of Bretton-Woods a form of ‘gold-standard’ defined money as a commodity and after 1945 exchange rates were based on the opinions of American, British and Frech policy makers. Bretton-Woods collapsed because the global power balance changed as the German and Japanese economies grew faster than those of Britain and the U.S. In order to regulate exchange rates in this new world order governments adjusted central bank lending rates. In the 26 years between 1945 and autumn 1971, the Bank of England changed its lending rate 41 times, with 30% of these changes occurring between 1966 and 1971. In the 26 years after 1971, it changed them 216 times. As exchange rates fluctuated so did commodity prices. An exemplar is the oil price whose control passed from the Railroad Commission of Texas to OPEC and ultimately to the Brent crude futures price, where jobbers on the International Petroleum Exchange controlling the price muting the owners of the rights to produce Brent crude. In 1908 and 2008 markets were dominated by jobbers because their role in ‘price-discovery’ was necessary in an uncertain world.

Market-makers gain from investors who are taking strategic decisions of the C -M -C type but lose out to ‘informed traders’ engaged in M - M'' type speculation (Bagehot, 1971:13). Brenner and Brenner (1990:91) argue that ‘investors’ are preoccupied with future scarcity and so defer income. Because uncertainty exposes the investor to the risk of loss, investors wish to minimise uncertainty at the cost of potential profits, this is the basis of classical investment theory. ‘Gamblers’ will bet on an outcome taking odds that have been agreed on by society, in a discursive manner as in sporting bets, or based on stable statistics, as in roulette. ‘Speculators’ bet on a mis-calculation of the odds quoted by society and the reason why speculators are regarded as socially questionable is that they have opinions that are explicitly at odds with the consensus (Beunza and Stark, 2012:394).

Gambling is today regarded as profane, but this was not always the case. For the Greeks, the brothers Zeus, Poseidon and Hades cast lots to divide up the universe. The Hindus believe the world was a game of dice played between Shiva and his wife and at the heart of the epic tale Mahabharata is an, unfair, dice game between the Kauravas and the Pandavas ((Sahlins, 2003:27), (Brenner and Brenner, 1990:1-5)). Divination by casting lots played an important role in Judaism and the Bible refers to the ‘judgement’ of Urim and Thurim, which were probably two dice (Exodus 28:30, Leviticus 27:20-21, Samuel I 14:41). Gambling was often associated with sacrificial practises that were widespread and are generally known by their Native American name, potlach ((Keynes, 1936:17-19), (Graeber, 2011:56)).

The role gambling plays in archaic societies has been studied by Altman (1985) and Mitchell (1988). Altman studied an Australian aboriginal group that had access to social security payments and there was often a surplus left over after essentials had been bought. However, some individuals were excluded from social security payments by the government and there was an “inter-household variability in access to cash”. The community regarded this variability as a subjective discrimination by the Australian government and gambling “acted effectively to both redistribute cash †[and] provided a means for people with no access income to gain cash” (Altman, 1985:60-61). This was important in non-hierarchical communities because it meant that one arbitrary bestowal of money was not corrected by another subjective distribution, such as redistribution by a chief. Mitchell considered the role that gambling plays in disrupting hierarchical social structures, such as the Indian caste system, by studying the Wape, a Sepik community in New Guinea, and concluded that their non-hierarchical society was maintained through gambling. The pervasive nature of gambling in archaic communities can be explained as it is an objective, ‘fair’, mechanism for the redistribution of wealth (Sahlins, 2003:27). What needs to be recognised is that this process remains valid only so long as no single entity accumulates enough wealth that it can bankrupt all the others.

Gambling had been outlawed in the medieval period, usually because time spent gambling could be better used (Brenner and Brenner, 1990:58). However, building on Roman practice, lotteries began to be used as means of raising public-finance in the later Medieval period. The first private lottery appeared in the sixteenth century in Italy and the mechanism spread to France and England (Brenner et al., 2008:133-138) culminating in ‘The Million Adventure’ lottery set up by the English government and drawn in November 1694 (Murphy, 2009:34). In the seventeenth century, William Petty, observed that lotteries were “a tax upon unfortunate, self-conceited fools” and from the start of the eighteenth century gambling became increasingly associated with “the waste of time and money; the neglect of familial and business duties; the erosion of social trust; and the severed link between hard work, talent and gain.” (Daston, 1998:161).

Brenner et al. (2008:98-104) argue that the de-legitimisation of lotteries, and gambling in general, comes about because during the seventeenth and eighteenth centuries there was significant social and economic change. In this environment gambling and speculation provided the ‘lower classes’ with a means to climb up the social ladder . While the lotteries enabled this disruptive social mobility, they were a necessary tool of public finance that prevented the stagnation and crises suffered by states reliant on taxation (Nash, 2000). By the start of the nineteenth century, finance had developed to such an extent that governments could tax more effectively, notably the incomes of the middle classes, or to borrow from the middle and upper classes. In 1808 the British Parliament set up a committee to “inquire how the evils attending Lotteries have been remedied by the laws passed”. The parliamentarians concluded that, despite the fact that the British government was still raising money through lotteries, “the foundation of the lottery system ...under no ...regulations ...will it be possible ...[to] divest it of ...evils” (Brenner and Brenner, 1990:12). The status of lotteries was changing and in 1823 they were outlawed, with the last draw taking place in 1826, the working classes were excluded from the opportunities to get rich that participating in public-finance, by purchasing lottery tickets, provided. .

Daston (1998:172-174) argues that usury prohibitions inhibited the use of mathematics in insurance and for much of the seventeenth and eighteenth century life-insurance provided people with the opportunity to gamble on the lives of others. The first life-insurance fund to be managed on the basis of mathematics was the Scottish Ministers’ Widows Fund established in 1744 (Hare and Scott, 1992). The model was copied in the Presbyterian’s Ministers Fund of Philadelphia in 1761 and the following year the English Equitable Company was founded. Mathematics and life-tables would enable the emerging middle-classes to provide, responsibly and prudently, for their families in the event of their death. By the end of the century ‘gambling’, in the form of insurance, had become a legitimate practice if based on rational foundations (Zelizer, 1979; Daston, 1987) and in 1774 the Life Assurance Act distinguished between legitimate insurance and illicit gambling and became known colloquially as the Gambling Act.

The prohibitions on gambling had an important impact on the development of finance. In 1851, following a dispute between two counterparties in a forward contract, English law established that there needed to be ‘intent to deliver’ for a derivative to avoid being classed as an illegitimate gamble (Swan, 1999:211-213); the only legitimate exchange was of the C - M - C type, M - M'' of the duction trade and ‘bucketshops’ was illegitimate. While English courts generally avoided becoming involved in the derivative markets, U.S. courts were much more active in restricting speculative behaviour and were vigorous in prosecuting “idlers who made profit even while they slept” (de Goede, 2005:62, quoting Fabian) by speculating in bucketshops rather than the “competent men” of CBOT engaged in “the self-adjustment of society to the probable”, as the U.S. Supreme Court ruled in 1908 (de Goede, 2005:71). We stress how the Supreme Court ruled that only an elite could speculate on the markets just as they prevented the poor from betting on horse-racing by only allowing on-course betting relate these observations to Levy (2012)’s account of the alienation of the public from financial risk by U.S. corporations at the end of the nineteenth century.

The strict prohibitions persisted into the late twentieth century and in 1968 CBOT consulted lawyers about offering an index future, but had been told it would probably be ruled as illegal. While commodities, including stocks and bonds, could be delivered, the ‘index’ could not (MacKenzie, 2008:145). The publication of the Black-Scholes equation, where all the variables were ‘known’, removed uncertainty in pricing options and meant derivatives trading was not gambling, it was, like insurance, ‘scientific’. In similar circumstances, in 1997 the International Swaps and Derivatives Association (ISDA) sought the advice of an English barrister as to the regulatory status of Credit Default Swaps (CDS): the ‘Potts Opinion’. The issue was two fold: on the one hand iff CDS were insurance contracts they would be regulated by strict insurance law while if they were wagers, they would be subject to gambling legislation. A CDS is a contract where by a protection buyer pays a regular premium to a protection seller over a fixed period. If the contract underlying the CDS defaults (a strictly defined term that goes beyond fails to pay) then the protection seller pays a specific amount and the contract ceases. Potts argued that, since the amount the protection buyer receives is independent of the loss they incur and the related feature that protection buyers do not need to have an interest in the underlying, the CDS is not an insurance contract. The CDS is not a ‘wager’ since the protection buyer and seller do not hold opposite views of whether the underlying will default or not: there is no winner or loser.

The Bible suggests that humans suffer because they were expelled from the Garden of Eden into a world of scarcity. The thirteenth century rabbi, ben Maimon (Maimonides), argued that God’s punishment was not so much about scarcity but uncertainty. In the Garden of Eden humans had perfect knowledge, which was lost with the Fall and it is the loss of this knowledge which is at the root of suffering: if we know what will happen we can manage scarcity (Perlman, 1997). Classical economics seems to hold an implicit assumption that the price of a commodity can be known. Sometimes in economics uncertainty comes to dominate and during these periods the central problem facing markets is how to price an asset whose prospects are radically uncertain. Keynes (1921:321-322) recognised this when he observed that the largest class of problems in economics were not reducible to the conventional concept of probability: the problem is one of ontology, numerical probability economic events in the future does not exist. Ramsey (1931:181-183) criticised Keynes’ rejection of mathematical probability by introducing the ‘Dutch Book’ argument (Hájek, 2008) that argues probabilities (which are proxies for prices) can be ascertained in a market-mechanism: Ramsey argues for a subjective view of probability and that “Having any definite degree of belief implies a certain measure of consistency”, or sincerity.

We offer the conjecture that at times of economic uncertainty, such as when new markets are being established through either globalisation or technology, jobbers become essential in discovering prices through a discursive process that rests on sincerity. At such times we cannot rely on enlightened authority to value assets and must involve speculative traders in setting prices: it is a co-operative process as defined by Gide (1898). This conjecture seems to be aligned to Sotiropoulos et al. (2013) where it is argued that profits made in the presence of uncertainty need not be exploitative.

The pragmatic maxim demands we consider the practical consequences of our assertions. To this end we consider the claim that sincerity is fundamental to successful markets by examining the practice of ‘order stuffing’ on electronic exchanges, the status of Credit Default Swaps (CDS) and the role of Collateralised Debt Obligations (CDO) in the Credit Crisis of 2007-2088.

The two women in the Vietnamese proverb do not require the mediation of a broker but in this situation we can presume, because the owner of the duck is not specified, that the price is a sincere price at which the women would both buy and sell the duck. Modern markets, whether financial or consumer, where technology facilitates the matching of buyers and sellers for a relatively small fee, appear to follow this model. However in the domain of High Frequency Trading the practice of ‘order stuffing’, issuing large numbers of orders to an exchange and then cancelling them within a tenth, often a hundredth, of a second is widely regarded as being an attempt to manipulate the market. While acknowledging this concern, the UK Government Office for Science has not advised that any legislation should be enacted in order to prevent the practice. They argue that there is a competitive market in exchanges, and legislation would discourage trading on the UK exchanges (Foresight, 2012, Section 8.2). This fails to appreciate lessons of the LIBOR manipulation scandal, that sincerity is foundational to the markets, and submitting and then cancelling orders signifies a lack of sincerity.

The Potts Opinion is not in the public domain and so we cannot be certain of its full purpose but what is apparent is that his argument seeks to legitimise the pricing of credit risk through jobbers rather than brokers, whether ratings agencies or brokers. This means that ‘informed traders’ are able engage in discourse about the liklihood of credit defaults in the future, rather than limit the discussion to investors with vested interests. Some claim that because CDS are so like insurance contracts they should be treated as insurance contracts, in particular that not requiring a CDS protection buyer to have an economic interest in the underlying creates moral hazard. Kimball-Stanley (2009:253-261) gives a number of reasons for re-classifying CDS but none of them is convincing⁵ and all overlook the negative impact insurance companies, such as AIG, and ratings agencies had in the Credit Crisis of 2007-2009.

With regard to the Credit Crisis in general, MacKenzie (2011:1811) makes the point that the financial instruments at the heart of the crisis were not priced using the jobber mediated “canonical-mechanism market”. Valuations were based on ratings provided by agencies paid by the producer of the financial instruments (a broker mediated model) and mathematical models using parameters based on unrelated markets. Because these parameters meant the models pointed to arbitrage profits, they were widely used with only a few exceptions (Tett, 2009:148-151). This example leads us to distinguish to cases of financialisation. There is the one discussed in the previous section where by jobbers price in the abstract and apply subjective judgement. There is a second where ‘quants’ abstract and employ algorithms and data, what might be described as objective judgement, in a strategic manner. The second form of abstraction failed, as most experienced traders believed it would (Tett, 2009; Triana, 2009; Haug and Taleb, 2011; Duhon, 2012). From a mathematical point of view the failure of the models was in their instrumental use; the legitimate use of mathematical models is to develop a clearer understanding of what can be inferred about market sentiment from jobber-mediated market prices so that trading decisions can be taken ((Johnson, 2011); (Beunza and Stark, 2012:384-385); (Duhon, 2012:265-277)).

We can conclude that some form of jobber-mediated market mechanism, based on sincere discourse about prices in an uncertain environment, is essential for markets to perform as they are expected to. The Committee on the Global Financial System (2014) of the Bank for International Settlements has observed a decline in market-making activity that is regarded as problematic. They argue that regulation has reduced the ability of jobbers to provide liquidity - by taking on risk - and this liquidity gap will have broader economic consequences. This raises a question: why does economic theory advocate market liquidity?

Liquidity represents the ease with which an asset can be traded. The economic justification is that it enables investors to trade as and when they wish, it gives them a sense of control, market risk has been tamed (Bernstein, 1998) by the investors ability to dynamically hedge, which rests on the market being liquid. Furthermore, the investor wants to, simultaneously, be able to exchange, implying a shift in supply and demand, without changing the price. Illiquid financial markets involve wider bid-ask spreads, or higher absolute commissions, representing higher transaction costs and less certainty that the market price is an accurate reflection of the asset’s value. Liquidity is an essential assumption of the Efficient Markets Hypothesis (Fama, 1970) where it is taken that the “primary role of the capital market is allocation of ownership” and so prices must “provide accurate signals for resource allocation”.

The instrumental, as distinct from the epistemic, use of mathematics in finance to hedge and earn arbitrage profits relies on markets being liquid. Canonical failures in recent finance, such as Metallgesellschaft AG in 1993, the hedge fund Long Term Capital Management (LTCM) in 1997 (MacKenzie, 2008:233-239) and during the Credit Crisis (Brunnermeier, 2009) all relate to financial strategies that failed because liquidity disappeared. This is not a modern phenomenon, in 1706 Defoe explained the liquidity problem in the debt markets in this description of ‘Lady Credit’

Money has a younger sister, a very useful and officious Servant in Trade ... Her name in our Language is call’d CREDIT ... 

This is a coy Lass ...a most necessary, useful, industrious creature: ...a World of Good People lose her Favour, before they well know her Name; others are courting her all their days to no purpose and can never come into her books. 

If once she is disoblig’d, she’s the most difficult to be Friends again with us (de Goede, 2005:28)

The economic role of liquidity can be summarised as in facilitating the strategic action of investors. Before the Enlightenment liquidity risk, and related market risk, seem to have been an accepted feature of finance. The ‘instrumental mindsets’ that came to dominate in the nineteenth century. However, the tools that control market risk rely on liquidity, and, in the aftermath of the Credit Crisis, we see an emphasis in the financial and economic on focusing on ‘liquidity risk’. Under the current regulatory framework liquidity providers are likely to be highly capitalised institutions, global investment banks or hedge-funds employing algorithms, seeking to make a profit. Based on the analysis presented here, noting Attard (2000)’s observation that most English jobbing firms were small partnerships risking their personal capital, this approach has two drawbacks. Firstly, these institutions will not be that heterogeneous and so susceptible to ‘group think’/‘herding’/‘the superportfolio effect’: there would not be the pluralism necessary for the discourse required in price-discovery. Secondly, these institutions have power and so could come to dictate prices: ‘order stuffing’ is a manifestation of this.

In light of this observation we can state the main result of this section as a question: should society see the principle role of markets as either; facilitating the strategic action of investors; or, delivering prices of assets. We note that a market can always deliver prices, with the bid-ask spread acting as a confidence interval, but it frequently fails to deliver liquidity.

These comments suggest regulatory policy should create a clear distinction between firms undertaking brokerage and those involved in ‘jobbing’, making it explicit which institutions are ‘speculating’ and which are ‘investing’. This implies support of the ‘Volker rule’ in the U.S. and reversing some of the regulatory changes associated with the U.K.’s ‘Big Bang’ reforms of 1986. This would address one of the issues that Kimball-Stanley (2009:257-258) identify: the fact that while one part of Goldman-Sachs was manufacturing Mortgage Backed Securities (MBS) and selling them to customers, another part was using the CDS market to speculate on the value of the MBS falling. The speculators were right and were able to signal their beliefs by trading in CDS, yet rather than criticise the process of manufacturing MBS Kimball-Stanley (2009) seeks to silence speculators by banning CDS. What Goldman-Sachs was doing was mis-selling⁶ MBS to customers because, as an institution, it did not believe the products had the value they were marketing them at: it was being in-sincere.

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¹ The New York Stock Exchange employs the ‘specialist’ system that combines the role of broker and dealer. From our perspective this is a degradation of the market-maker’s particular role for the benefit of the monopolistic specialists.

² W. Bagehot was a pseudonym for Jack Treynor.

³ Arbitrageurs aim to ensure prices of many assets in the market are consistent, a practice described by Fibonacci eight hundred years ago (Fibonacci and Sigler, 2003:180).

⁴ While ‘confusion’ has long meant disordered, in metallurgy, a branch of finance in the seventeenth century, it was used to refer to the point at which metals, such as gold and silver, mix as molten liquids - ‘com-fundere’ = ‘with pouring’. Confusion de Confusiones may be a pun implying a disordered mixing.

⁵ In A, the hedge-funds had an insurable interest; B, ratings agencies had a bigger influence on pricing mortgage default than CDS; C, banks win and lose with CDS - that’s the point of market-making; D, disassociating payout from loss does create moral hazard if there is an insured interest, standardising payout enables price discovery.

⁶ In January 2016 Goldman-Sachs reached a $5.1bn settlement with the US government and other agencies for mis-selling mortgage-backed securities in the run-up to the financial crisis