Welcome to the fourth blog in our series on liquidity. If you haven’t done so already, please read our previous pieces: What is liquidity?, What is a liquidity provider?, and Diversity in liquidity provision. We began by discussing what constitutes liquidity and the role of liquidity providers in modern markets. We also addressed why having a diverse mix of liquidity providers benefits markets.
In our last piece, we explained that while the degree of liquidity in a market can be quantitatively evaluated, we can’t qualitatively judge liquidity; it’s either present or it isn’t. (For another view of this, see FIA EPTA’s blog: Liquidity and Quote Fading).
So how do we evaluate the degree of liquidity in markets? And how can we optimize market structure to promote liquidity?
There are a number of factors that allow us to measure the degree of liquidity in a market, including the size of the bid/ask spread, the depth of book, the traded volume, and the composition of an order book. All-in execution costs for large and small orders are also important metrics. The audit trail that comes with electronic trading in central limit order books (CLOBs), along with real-time dissemination of market data, makes it easy to analyze these measures of liquidity. Most of these measures have improved materially over recent periods as markets have become more electronic, more transparent and more competitive.
And now to perhaps the most important discussion about liquidity: how can we best promote healthy, liquid markets?
Enhanced transparency is one critical tool. Improving a market’s ability to reflect all relevant information in real-time increases efficiency and bolsters market participants’ willingness to provide liquidity. With clear insight into market operations, liquidity providers are better able to manage risk and provide liquidity.
Open and fair access to markets is another key to unlocking liquidity. Limiting participants, whether directly or through difficulty of access, increases concentration risk and decreases liquidity, especially during periods of market stress. For example, during the 2008-2009 financial crisis, liquidity suffered in off-exchange venues, while exchange-traded, transparent, competitive, centrally-cleared markets with broad participation operated continuously and fairly smoothly. Having transparent access to data on diversity of liquidity provision allows market participants to determine if there is concentration risk in any single market.
Conversely, there are factors that can impede liquidity provision. Excessive fragmentation, complexity, and limited market access all harm competition and discourage liquidity in markets. Artificial latency mechanisms at exchanges, or speed bumps, can be barriers to liquidity provision. Equity market rules require orders to be routed to exchanges displaying the best price. As the SEC considers latency proposals from multiple exchanges, we risk creating a hall of mirrors where market participants are forced to route orders to delayed exchanges, only to encounter stale quotes that are no longer accessible. It will be impossible to know which prices are real and which are latent reflections. This could lead to decreased liquidity, lower fill rates and inferior executions.
In the coming months, FIA PTG will be expanding on the idea of liquidity provision and drafting a white paper that will discuss how to enhance the degree of liquidity in our markets today. We welcome a robust conversation on this topic with market participants, regulators, and policy makers.