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Economist questions FSI report

A British economist has criticised the Financial System Inquiry (FSI) report for having a misguided emphasis on liquidity and price discovery.

Speaking at a Sydney event, John Kay questioned the idea that financial markets must be extremely liquid, which was included in David Murray's recent FSI report.

The report's opening pages state: "The financial system plays a vital role in supporting sustainable economic growth and meeting the financial needs of Australians.

"It does this by facilitating funding, liquidity and price discovery, while also providing effective risk management, payment and some monitoring services."

Mr Kay said the primary activity of the finance sector is now to "trade with itself".

"What we have now is a finance sector in which the primary activity is actually trading in secondary markets," he said.

He pointed out that the volume of trading in foreign exchange is 100 times greater than the trading in goods and services.

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"The value of exposures under derivative contracts is under the order of $700 trillion, which is something like three times the value of all the assets in the world," Mr Kay said.

When it came to the FSI, Mr Kay said he was struck by its focus on liquidity and price discovery as being key to the efficient functioning of markets.

"I stand back and ask myself – why do we need a great deal of liquidity? And what is price discovery and its relevance?" he said.

"The majority of people are long-term savers for whom markets provide more than enough liquidity.

"If [markets] opened once a week or once a month, or perhaps once a year [that would be enough] – the notion that markets need to trade every millisecond in order to do that [is absurd]," he said.

When it came to price discovery, he was quick to differentiate it from 'value discovery' for people who work in long-term asset allocation.

"Price discovery is about trying to assess the opinions of other people in markets about things that are being traded in markets," Mr Kay said.

"It's not very clear what it adds to the function of the real economy. And to the extent that it impedes value discovery, it actually gets in the way."