The Rules, Part XXVI (Efficiency vs Stability)

T+1 will raise volatility.  Often increases in the technical efficiency of information or trading systems increase volatility, because people can act precipitously on information, all at the same time.

There was an effort in the early 2000s to make almost all securities settle as a rule in one day.  Three days was the rule for most markets then, as it is now.  Government bonds settle differently, and some other securities as well.  The effort to settle transactions more quickly failed, and we still settle trades in three days.

I was glad when the move to T+1 failed.  There were efforts to move to T+0 behind it.  Not that I had many trades that I needed to break as a bond manager (I had one, the phone call to do so made me ill), but I knew there were settlement failures even at T+3, and the stress on the back office would be considerable.  Better to go slower, and have fewer failures.

I prefer stability over efficiency.  Efficient systems tend to require high attention.  Stable systems have redundancy.  Not everything has to go right for the system to work.  In my example above, T+1 required a lot more accuracy, and T+0 would be unimaginable.  We would need angels to clear trades.

That’s one reason why I am not crazy about market efficiency.  Yes, efficiency is a good thing as far as it goes, but when it begins to impact stability I part ways with efficiency.


It is inefficient to have a balance sheet.  All of the slack capital that you don’t need all of the time.  Far better to be a trader with no significant balance sheet, the profits will be greater.

I disagree.  Though this is an extreme example, look at Buffett with his purchase of Bank of America preferred stock with warrants.  In a single stroke, he protected the downside, and allowed for the participation in the upside.  He probably understands that his credibility can move markets.  The preferred stock can be stuffed inside an insurance entity with little capital cost, while the warrants can be held at the holding company.

Bank of America entered into expensive financing with Buffett who had cash at a critical moment.  Give the Buffster props for his cleverness in the tub — he understood their need of capital, and gave it to them in away where they could deny the need for new capital.  Brilliance.

Brilliance, so long as the losses never reach down into the preferred equity portion of their balance sheet.


Having a balance sheet allows for modest losses to occur and the system does not fail.  But it means that some capital is not deployed; it is there in reserve for disasters.

That is why financial systems with excess capital survive better.  Yes, it is inefficient to carry capital that does not earn much, but it is more inefficient to fail.  Think of the Baumol model, where there is an economic order quantity.  The same can be applied to finance, where the is a level of efficiency below which we should not go, because of ordinary volatility.

Volatile markets require intermediaries, or at least, systems that slow settlement.   Slack in the system is not wasted, but is there to protect against catastrophes.  That is a benefit to all, even those that seek to make markets more efficient.