Odd Lots - What We Can Learn About Market Liquidity By Looking At Everyday Life

Episode Date: October 9, 2017

"Liquidity" is one of the most widely-talked about yet least understood concepts in markets. Roughly speaking, a market is liquid if you can transact in it without affecting the price significantly. But there's little agreement about why some markets are more liquid than others, or why liquidity sometimes just evaporates with little notice. This week we speak to Karthik Shashidhar, the author of "Between The Buyer And The Seller" about what we can learn about liquidity from things like Uber, dating apps, and real estate brokers. See omnystudio.com/listener for privacy information.

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Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio. and wherever you get your podcasts. Hello and welcome to another episode of the Oddlots podcast. I'm Joe Wisenthal.

And I'm Tracy Alloway. You know, it was really fun last week. You know, really enjoyed getting to record an episode in person for once. But now, of course, we're back to our normal ways. It's very sad. I miss you, Joe. Likewise. And here we are recording a podcast on opposite sides of the world.

But, okay, moving on. Today, I think we're going to be talking about something that we've covered in a few episodes and that I think is one of your favorite themes. Okay, because you said that, I know exactly what it is. So we don't have to play the guessing game like we sometimes do? No, it's liquidity, right? Right. Why is this one of your favorite topics? It's funny, we've talked about it a lot, like this sort of, it's particularly the bond market, bond market liquidity, market structure.

We've talked about it a lot. But I guess I've never asked, like, why is this a subject of such fascination for you? Okay, I can tell you exactly why. Because liquidity is almost the essence of markets. Like, if you think that a really simple definition of liquidity is the ease of buying or selling something maybe without affecting its price too much, that's exactly what markets are, right? And the other thing is you get all these really interesting motivational. dynamics at play and lots of design issues. And even though you can think of the perfect market structure to suit a particular asset class or transaction, there might be different players

involved who don't want to see that market structure come to fruition. So it's a fantastic mix of human behavior and markets, I think. So basically this idea of liquidity, the ease with which one can buy or sell an asset at a given price. If we can understand why, you know, why it exists or why it doesn't, then we can sort of understand the entire structure of the market, who the different players are, what their different motivations are, et cetera. That's exactly right. Are you telling me we have someone on the show today who knows the answer to this question? Well, we might.

I don't know if we have the answer, but we're going to try and get closer to the answer. But I think we're going to do it in a cool way because obviously normally, you know, we might talk to someone we have who's like an expert in how the bond market works or stock market structure. Today we're going to talk about how this concept of liquidity and market structure exists in our everyday lives, so not just in what we call financial markets, but in the sort of how we see this concept everywhere and the things we buy, transact in, etc. That sounds absolutely amazing. And I hope we can come up with some real life parallels for, for instance, lack of liquidity in the corporate ball market. That would be fun. That's what I'm

hoping for it. I'm hoping that by understanding how liquidity exists in everyday life or lack of it, that we can then translate that back into maybe some new insight into the financial world. So without further ado, I want to bring in our guest. His name is Karthik Shashudar. He is the author of Between the Buyer and the Seller, a book that examines some of these topics. Carthic, thank you very much for joining the Oddlots podcast. Hi, Joe. Hi, Tracy. I'm glad to be here. So, Carthic, what did you think about our introduction? Did you think that Tracy's explanation for why liquidity is such an important aspect of the market to understand sort of parallels with why this interests you? Absolutely. I think she's kind of bang on. And I think the definition of liquidity

she used is also like precisely the one that I use in my book. But yes, liquidity, I think is an important topic because it's around us everywhere. It's around us in pretty much every market that we happen to transact in on a daily basis. And like, as Stacy just explained, it's a wonderful combination of markets and human behaviors. So we always used to write that liquidity is kind of a nebulous concept and people have different definitions of good and bad liquidity. So why don't we just jump right into it to clarify the concept? Give us a real life example where liquidity is an issue or that tells us about one specific aspect of liquidity? So I'll start with liquidity itself.

I'll start with a quote that I have, that I begin my book with. It's by Michael Lewis and it's from Flash Boys. And he says liquidity was one of those words Wall Street people threw around when they wanted the conversation to end and for brains to go to date and for all questioning to cease.

This book is basically an attempt to kind of like take liquidity beyond its kind of Wall Street origins. I myself have a little bit of a background in Wall Street. I briefly worked for a couple of years at Goldman Sachs and now I'm working in the financial services industry, working for a company called RKerat where we are trying to revolutionize how client engagement is done in investment banks. That aside, I think to coming back to liquidity, to take a very simple example that I think a lot of us kind of deal with every day. it's to do with the market for what I call as motorized local transportation. That's cabs and cab-like instrument pretty much everywhere.

So one of the biggest kind of, it was actually one of the motivations for my book in terms of like one of the markets that have seen a massive revolution in liquidity is the cab market, which had kind of existed in a fairly low level equilibrium for a lot of years. I mean, different, the regulation was different in different cities. but pretty much each city was broken in one way or the other. Like, for example, in a lot of cities in India where I come from, it's common for taxi drivers to refuse you a ride once they know where you want to go.

Or, for example, taking the example of New York City, in the mornings if you're trying to take a taxi from Midtown to Downtown, it's highly unlikely that you're going to find one. This was a market which was kind of very, very inefficient. It was, people had tried to regulate it in a whole lot of ways, but like none of it had really worked out. And then comes along this company called Uber, which using an app and using this concept of dynamic pricing, which is highly controversial. But I mean, I absolutely love it, by the way. They have kind of changed the way, changed the way, changed the,

taken the liquidity in the cap market to a whole new level. So there's several ways. I think obviously it's great that we're starting with the Uber discussion because it's probably one of the most clear ways in modern life in which something we just took for granted, you know, putting out your hand and getting a taxi is really a sort of quasi-financial market and the new market has changed. So there's dynamic pricing. There's the fact that, you know, the Uber's.

have to take you everywhere. You can sort of see the supplies that's on the road more vividly because you know, you're not just sort of wondering when a cab is going to come around. You can set up timing very well. In your view, A, what is the most sort of radical thing about Uber? Perhaps it's the dynamic pricing. And then, you know, since we're looking for financial market lessons, what is sort of, is there an Uber equivalent in the world of finance that we could say, okay, this thing that Uber does is similar to this on an exchange? Good question. So the first part you got Bangon, I think the most important part of Uber is dynamic pricing.

In financial markets, I can't think of a direct parallel right now. I can't think of a direct parallel where like where, let's say, an intermediary, Uber is also an intermediary between the cab driver and the passenger, where an intermediary uses kind of dynamic pricing to kind of make the markets more efficient for everyone. I think Uber, one of the work of the taxi market is that it's extremely fragmented when it comes to both space and time. The market that you see is limited by the taxis that are, you as a passenger, you see the taxis around you at that point in time.

So there's massive fragmentation on two dimensions. And that kind of fragmentation, I mean, you can say that like even our regular stock or bond markets have that kind of fragmentation because there are like, there are like, you have like multiple venues and you have like kind of there is fragmentation through the day because there are some market makers who operate more heavily at different times of the day and volume changes through the day and so on. But the key difference between Uber and a kind of a stock market is that like in a stock market by providing supply in one place, you're not. taking supply away from another place. So, for example, if I am Golden Sacks and I am participating right now in the New York Stock Exchange, that doesn't come at the cost of my participation at this point of time in NASDAQ. If I had to kind of choose between one or the other, then it would have been more like Uber. So in that sense, I mean, like, I got, it's hard to, at this moment, draw a direct parallel between Uber and financial markets

because Uber is a far more complex problem, I would say. So Uber is a great example of a sort of technological change that has arguably boosted liquidity or the availability of a certain service. But there are existing assets or services out there that have also resisted technological change. And I think you brought one of them up in your book. And I'm particularly interested in this, the real estate market, the concept of all these real estate agents who find you a house or an apartment. there have been multiple attempts to make that market more liquid, either with online platforms or some other new big ideas. And they seem to have largely failed. So why is it that liquidity hasn't come to the property market and we all still have to pay, you know, obscene commissions

to New York real estate agents? The thing with the real estate market is that like the way in which the new players, like take somebody like a redfin in the US or housing in India, the way they're approaching the market is very different from how your local real estate agent approaches the market. So here I bring in an analogy in the book from the financial markets and try to distinguish between what I call as brokers and clearing houses. For this podcast audience, I don't think I need to explain those two terms. So the difference between your tradition. Wait, actually, I do think a quick definition of the two terms would be helpful because I get confused myself and I think, I suspect we have a lot of listeners that would like a clarification.

Okay, so brokers basically take a mandate on behalf of a client and take responsibility for executing the trade on behalf of the client. Clearing houses on the other hand don't really take a, they don't work for a particular client. They just provide a platform where clients can come on and find each other and transact. So the way the traditional real estate industry has been set up with the brokers, brokers are brokers. They take a mandate from the, I tell them, I want a two-bedroom apartment on the Upper West Side and I'm willing to pay up to $2,000 a month. And they will take that mandate and possibly try and find me a house if one exists, if there is supply for it and so on. On the other hand, If you take something like housing, I'm taking an Indian example because that's what I'm

most familiar with, but what they do is it's an online portal where I as a seller of a house or a landlord can list my house and you as a buyer or a tenant can come and search for listings. So Redfin or Housing doesn't take a mandate on behalf of the client. So they just kind of enable transactions. And what happens because of that in the real estate market because like no two houses are similar and there's a lot of quarks and like people have weird preferences. I think what's happened is that like it's very hard for the clearing house to kind of really offer the precise like offer a really short list. So if you want, if you have a particular set of preferences and you might put in those filters on the website and you'll get a really long. list and the effort required in going through that and eliminating the stuff that you don't want is pretty high.

So on the other hand, a broker as a human being, his advantage over the platform is that he can really represent you. You can clearly communicate to him what you're looking for and he can kind of find you precisely that kind of a deal and so on. So in that sense, they have been able to add value. And also, as I mentioned in the book, especially in India, brokers have kind of leveraged these online platforms because they have, I mean, it always happens in the stock market where your local broker goes and participates on your behalf on the New York Stock Exchange. So similarly, in the property market, you have brokers taking their clients' mandate

and going to one of these websites to find a deal and so on. I'm Francine Lacqua, an award-winning journalist, and I've got a new podcast, Leaders with Francine Lacqua from Bloomberg Podcasts. I've interviewed everyone from Heads of State to fashion icons about the news of the moment. But I've always been curious who are these people as leaders. I don't think there's one right way to be a leader. Make decisions. A poor decision is always better than no decision. Listen to new episodes every other Monday. Follow leaders with Francine Lacquan, wherever you get you. your podcasts. It is interesting hearing this explanation because, you know, once again, going back to sort of traditional financial markets, one of the themes that we've talked about is, you know, the degree to which the bond market is characterized by such a greater diversity of instruments than the stock market. And so hearing you explain, you know, each, each apartment or house that someone would want to buy is probably going to be a little different, even if they're sort of

can be grouped in general categories, any two apartments are not as fungible the way, you know, sort of every share of Microsoft is basically identical. Wait, so, I mean, I've heard that explanation for bond market issues, and it makes some sense. But the other thing to consider, and I'm pretty sure we've talked about it at various points on odd lots, is the motivation of the players involved. So a lot of people will say that the bond market is resistant to change. change because, for instance, the big dealer banks, the guys that buy and sell bonds on behalf of their clients, don't want to give up a really lucrative form of commission.

So, Carthic, I'm just wondering, in terms of everyday examples of market structures or liquidity, is there one that springs to mind where the participants in it have been, you know, basically unmotivated to change their ways? I'll probably go back to the kind of the taxi example because in a Uber obviously you know it's been fairly controversial in London where I now live Uber kind of has been effectively banned in its fairly recently and there's a huge controversy going on over there and there I think it's more to do with the fact that the fact that the traditional taxi industry has been like they have immense lobbying power and they have been kind of resistant to change in terms of like they have been

There have been a few ways in which there have been inefficient. Like, for example, even in the most well-regulated markets, you have the problems of taxis, not wanting to go into certain parts of town and so on. So what's happened there is that, like, I mean, one of the reasons you see the regulatory backlash against Tuber is because the incumbents kind of are kind of afraid of this threat and they want to kind of because they are sitting on fairly valuable assets. they're not valuable assets in terms of like as intermediaries which is what it is with the banks in the bond market here it more it is in terms of like they're sitting in terms of valuable

assets as the right to sell in this particular market think of the new york taxi medallion for example so so so they have been stymying all efforts to kind of reform the markets the because of their unwillingness to change but but yeah but because uber has shown a way out in terms of like it's increasing efficiency. It might not be a very, that might not be a fight that might last too long, hopefully. Let's see. Now, speaking of real estate, one of the, you know, with the rise of the internet, one of the big theories that people had was that geography would be destroyed. So, we can all work from anywhere. We could work from home. We could work from wherever. So there's no reason to live in New York or Silicon Valley or Washington, D.C., or L.A., and yet the opposite

seems to have happened. And you write about this in your book where, in fact, people, you know, cities and urban centers have become even more and more important for the economy, despite what sort of this theory of disrupting geography would say. What happened there? Why has that idea that the internet would sort of subvert traditional geography not really played out? Okay, so I think what we kind of ignore is in terms of to use some Silicon Valley speak here, that cities are effectively platforms. Cities can be viewed as platforms that connect employees on one side and businesses on the other. And at a different level they connect consumers of local goods and services to producers of local goods and services,

such as restaurants and so on. But we'll leave that aside right now. So what people had kind of vastly underestimated was the importance of proximity in terms of getting work done and so on. So what people had assumed is that with internet there is going to be like there is, it is going to be possible to kind of communicate seamlessly across great distances. And so you can sit in your farm and vowing and kind of work the same way as. somebody sitting in his office in San Francisco can. So I think that was something people assumed. And that has not come to be because there is always a transaction cost involved in talking to somebody who's not next to you. So you'll either have to call the guy and make sure he

understands what you're saying. And there can be various kind of places where like coordination across distance can kind of falter. And because of that, I think like companies have recognized the, um, recognize the need to kind of be in one place and so on. And so you have like the, uh, despite how expensive San Francisco has gotten nowadays, like people still continue to move to the Bay area and so on because that's where the kind of the liquid market for the skills that people have are. This is making me feel bad about working from our, um, Abu Jabi satellite office of my living room. Um, Carthic, I have a slightly more theoretical question for you. To what extent do systems of buying and selling reflect the nature of the

underlying assets, like if you have a bunch of really diverse things that aren't actually that fungible? And to what extent do they reflect the nature and the motivations of the parties involved? And which one would you give more weight to? That's not a very easy question to answer. I think it's highly interdependent. I think how a market has developed historically is a function of the kind of assets that are being traded in that market. So for example, I think one of the, if you have things that are like easily fungible, which is easy for a lot of people to provide, you would have seen that the market would have evolved such that like the overall transaction cost, even the overall. transaction cost is pretty low because competition drives the bid and ask close together.

When you have lots of products which are fungible, which can be easily traded. On the other hand, I think this is something I talk about in the first chapter in my book, which unfortunately my US readers may not really appreciate. It's about the markets in football players, football as an association football, where you have, because the players are not fungible at all, no two players. are, especially at the highest level, are very similar to each other, you see deals that happen that are either extremely expensive. We had recently a case of a footballer going for 200 million euros between a club in Spain

and a club in France. So it is like, on the other hand, you can have equally highly rated footballers moving between clubs without any transfer fee involved. So it's a highly kind of when you have less fungible kind of assets, the, you know, you, the deals take place at either the bid or the ask and so, like, you have a very, a bit of a crazy market. But, and I think that actually drives the behavior of the, that drives the behavior of the intermediaries.

I mean, like, if you're, let's say, an intermediary who, if you're making market in, markets in stocks and you decide to behave as if, like, stocks are, the stocks are a non-fungeable item and try to, charge, high bid ask, threats and things like, you will be easily priced out of the market. So I think it's the nature of the asset that's been traded that drives the nature of the market. Okay, I want to ask about another what one might call a market in which no two of the assets are fungible, but which has been massively disrupted by the internet, and that is the dating market or the marriage market or whatever you want to call it.

Obviously, extraordinary change in behavior with the rise of Tinder where someone can just sit on their phone and arrange numerous dates in the span of a few seconds or minutes. As far as I know, I've never used it. Yeah, whatever, Joe. Nice try. I'm way too old. I'm way too old. I missed all of it. Versus the old days where I guess theoretically you had to go to a bar

and it was very slow, cumbersome process to meet people and theoretically arrange dates. Tell us about this market. What are some of the lessons we can learn in liquidity from the dating market? So the dating market is again quite interesting, especially the way it has kind of, I'll again take the Indian example because it's a bit more interesting and less liquid than, I think, in other places. what you have in India is because of historical or cultural quirks, there's a massive gender imbalance on apps such as Tinder. So I think it's somewhere around 80, 20 or in favor of men or worse.

So what happens is that neither, let's just assume heterosexual relationships here. So what happens is that neither men nor women have a good time in the market. Because when you have like, let's say, five men for every woman or for 10 men for every woman in the market, if you are, I mean, Tinder to some extent is a little less bothersome compared to other apps because you only kind of, there's only a kind of only when there's a mutual like that like you get a notification. But what happens is that if you are a woman and there are like lots of men in the market but few other women, you'll end up getting a lot of kind of interest from a large number of men. And you know for sure right up front that maybe 90% of them are not your type.

So you have to, you have the job of kind of sifting through so many of these profiles and in order and to somehow find the needle in the haystack. On the other hand, if you're a man in such a market and what you notice is that there are like so many men for every. woman here that you need to somehow stand out and standing out in this kind of a market where your competitors are also evolving and so on is not easy so in that sense it's a very while theoretically it is i mean it's solved the liquidity problem to some extent in that like now if i go to a party and i switch on tinder i know that who else is on i can let's say i spot

somebody at a party and want to check her out and i can see if she's on tinder which where she probably will be if she is single and then like maybe express interest there without facing the fear of rejection. So in that sense, it's kind of increased the volume of trading or volume of interest in the market. But on the other hand, it is still not completely kind of solved the market because there is this whole issue of what they call as congestion. That's fascinating the idea that this sort of imbalance creates a broken market. And it sort of explains why bars, you know, often, I don't know if they still do. You know, they'd have like a ladies night.

Ladies night, yeah. To pay a cover, women got it free in order to, you know, keep the population's balance because with imbalance, it doesn't work out very well for either side. You know, ladies' night, sorry, I just have to interject, ladies' night is alive and well in Dubai and Abu Dhabi, and that's because the gender balance is so extreme. There are so many more men than women here. Carthick, before we go, we just have time for one more minute. Give us one quick other example from your book.

What's just one more thing in modern life that we see that's an interesting example of liquidity providing an action? So one more way is, I think I'll answer this question at a bit of a meta level. So take the publishing industry itself, right? So if you were to think of in the olden days before Amazon, what happened was if I were to, to want it to publish something in a book form and have it read by you, the transaction costs would have been immense in terms of because first I had to kind of put it on to get it printed onto a paper nicely bound and then like it has to kind of go through the entire supply chain of books and then my publisher will have to kind of do the marketing to make sure that you know that my book exists and so on. So there was a lot of cost, transaction cost involved in

terms of publishing and consuming books itself? I think what's happened is that with the, again, this is a market that's only like become partly liquid and there's still a very long way to go as I've figured out after kind of having published the book. Is that like after Amazon came about and kind of released the concept of the Kindle where all the dead tree in the publication process is taken away. So it's not funny what portion of the cost of my book goes into modifying and moving paper. And if you take that out, the amount of the value that the reader pays

that can be captured by the writer is immense. And so effectively, once you have the paper taken away, I think the biggest kind of transaction costs between the buyer and the seller is that the reader should know that the book exists and so on, which is, again, fairly big cost, but still, I think this is a market which is on its way to becoming a bit more liquid. Karthik Shashidar, fascinating conversation, the author of the book and question between the buyer and the seller, which explores concepts of liquidity and market structure in everyday life. Fascinating conversation.

Really appreciate you coming on the show. Thanks, too. Thanks, Steve. So, Tracy, do you think we are any closer to understanding the mystery of market liquidity? I mean, I think we may be mubbling the concept of liquidity with just service provision in that conversation. But that said, the thing that's endlessly fascinating about liquidity is the fact that everyone has different definitions and views of it. So even when it comes to the corporate bond market, you have all these investors or traders. who will say anecdotally that liquidity has deteriorated in the market. I was speaking to one credit guy today who told me it took him a week and a half to sell one million worth of bonds.

And then you have the regulators who will come out and do these studies and say, well, based on these hard data points, we see no problem with liquidity whatsoever. And it's just really interesting to me how you can't really get to the bottom of what ostensibly should be a fundamental concept in markets and finance. Absolutely. But, you know, I think, like, all of those different examples, some were more like financial markets than others. I think they tell us something profound,

which is that I think from a naive point of view, you could imagine that with the Internet, everything could suddenly just become a liquid market, where there's no more need for brokers, there's no more need for anything. you just put your information out there. I'm a person working in here. I want to, I have these skills, or I'm looking for this kind of person to date, or I'm looking for this kind of apartment, or whatever it is. And even, but it's still really hard. And different markets really do have fundamentally different

structures, or at least they have players, as you are alluding to, in those markets that can prove pretty effective at resisting change. And so in the same way, we just sort of imagine that in theory, electronic trading markets will disintermediate everything and you can just buy whatever you want by putting it out there. It's really not that simple. Yeah, so maybe the lesson is that even in a technological age, you can charge for liquidity as a service for certain assets, I guess. Right. And that even in a technological age, people have ways of sort of preserving the existing order and not everything is just, not everything is just so simple as a, you know, a, you know, gigantic eBay market or whatever it is.

Right. If something hasn't been disrupted before, there might be a reason for that. That's well-play. All right. Should we leave it there? Let's do it. This has been another episode of the Odd Lots podcast. I'm Joe Wisenthal. You can follow me on Twitter at the stalwart.

And I'm Tracy Alloway. You can follow me at Tracy Alloway. And you can find Carthick on Twitter at Carthick S. And you can find our producer, Sarah Patterson, on Twitter, at Sarah. Pat with two teas. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report delivered right to

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