Is greed good for market liquidity?
“The point is, ladies and gentlemen, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through and captures the essence of evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind.”
The decline in liquidity in the Nordic financial power market is attributed to a range of factors, and may well have more than one cause. However, one factor, hinted at in the above quotation from the famous 1987 movie “Wall Street”, is sometimes overlooked – the value of profit-driven innovation.
The Nordic power market was a success from its start in the ‘90s, providing a well-functioning wholesale market coupled with a simple, efficient and liquid financial market. Volumes grew rapidly, maybe too rapidly, and doubled from 2000 to 2001.
The first real test of the financial market came in 2002/2003, when Enron collapsed and took with them almost half of traded volumes. As is often the case, the crisis was driven by a mix of stupidity, greed, recklessness, risk-taking and hope.
In the years that followed however, all arrows continued to point upwards. Coal prices were up; gas prices were up; the carbon market came into force with high prices, and the power price went on to reach new highs. Financial volumes followed, although they never reached the levels seen before Enron’s collapse. With all factors pointing in the right direction, little effort was put into market innovation.
In 2008, we saw the effects of a mix of stupidity, greed, recklessness, risk-taking and hope hit the market again. Eight years after Lehman Brothers’ collapse cascaded through the financial system we have again seen half of the liquidity in the financial market vanish.
“You can’t legislate away stupidity and risk-taking and greed and recklessness. What you can do is make sure when it happens it does not cause too much damage and to do that you must make sure you have good rules against fraud and abuse, better protections and you force banks to hold more capital against their risk.”
Treasury Secretary Timothy Geithner
A wave of new financial regulation followed the financial crisis with the aim of increasing transparency and liquidity in financial markets. But this regulation has primarily been designed to cater for markets other than the Nordic power market. With tougher reporting requirements and higher trading costs, liquidity has suffered. In crafting financial regulation, there is a fine balance needed to limit excessive risk-taking in financial trading without hurting those firms that are not taking excessive risks. If too many small- and medium-sized companies whose positions in the financial markets do not pose any systematic risk to the market are subject to expensive reporting regimes, or face increased collateral costs due to their inability to use bank guarantees, liquidity in the financial energy markets will suffer.
Some seem to blame greed and the financial regulations intended to safeguard us from it, for the current lack of liquidity, and there is no doubt that these have caused problems in the past. Others point to small price areas with frequently changing borders, which may make the system price an ineffective hedge. Still more note low and declining power prices, which limit the downside and hence the incentive for utilities and industrial players to hedge. All of them may have a point. But could it in fact be a lack of greed, and a failure to innovate that is at least partly to blame? We all seem to have been surfing the wave of the most advanced, well-functioning and deregulated power market in the world without paying too much attention to developments the world around us. Why do the new energy users like Google, Facebook and others, prefer to use PPAs directly connected to new wind projects, rather than being active in the financial market? In addition to understanding the issues above, we need to ask ourselves whether the current downturn is a signal that we have not been developing the products the market wants and are failing to provide interesting hedging opportunities for new entrants.