Liquidity – at what cost?

Last week I read an interesting definition of arbitrage: "making money by buying and selling something without adding value." Those last three words began a train of thought that led to a conversation that led me to conclude that the world probably has too many arbitrageurs, and too many financial traders in general. Probably.

The primary purpose of financial instruments used to be for large companies to raise finance (through debt or through equity) and to hedge risk (through derivatives). Now it seems like their main purpose is to allow hedge fund managers and bank’s proprietary traders to make large profits.

In most industries, making a profit is achieved by adding value to some product or service and selling it at more than the cost of delivering it. The value added usually corresponds to a direct benefit for society – think of a baker turning flour into bread or a bike mechanic making a broken bicycle usable. One person’s effort allows them to earn a living while benefitting another person.

With the trading industry it is much harder to see who are the net beneficiaries - but they do exist. Speculators and arbitrageurs create liquid markets for financial instruments, which are important for companies to be able to raise finance with which to grow. Growth allows economies of scale, and public listings create a certain level of discipline amongst corporate management.

Having said this, I would argue that there are probably more people working in speculation and arbitrage than are required to make the financial markets liquid. The cost to society of the additional liquidity is that the people working as traders could have otherwise been adding value to society through industry or entrepreneurship. In this trade-off of the allocation of talent, there must be an optimal level of trading activity – enough to make financial markets work, without damaging other industries by sucking up too much brainpower – and I don’t think we are there.