Liquidity (Or Market Liquidity) Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Liquidity (or market liquidity) is the ease with which financial market participants can quickly execute large trades without significantly impacting prices. An investor buys a financial instrument in a liquid market with confidence that there will be a ready prospect for its sale in the future. In the absence of market liquidity, an investor faces liquidity risk or the financial risk that an asset cannot easily be sold. A financial instrument that trades in a highly liquid market carries less liquidity risk, which both encourages greater investment and reduces the funding costs of the issuer.

Another benefit of market liquidity is rapid price discovery. New information is an important driver of market trading. Dispersed beliefs of traders on an asset’s equilibrium price as a result of any new information may converge toward a consensus more quickly in a more liquid market. Alternatively, on liquid stock exchanges characterized by the participation of many uninformed liquidity or noise traders, informed speculators may be able to trade more profitably on private information, which, in turn, increases both the returns to monitoring management and the informational content on management performance in a stock’s price.

The benefits of market liquidity may also be seen as a public good that may justify a role for government in its maintenance. The significance of sound financial markets for stable economic growth and the reliance on them to guide and transmit monetary policy have also led to increased concern for the maintenance of market liquidity. Illiquidity in financial markets may have serious consequences for overall economic activity. With responsibility for the safety and soundness of financial systems and in their role as lender of last resort, central banks are critical to the provision of liquidity to illiquid markets.

There is no one universally accepted measure of market liquidity. The degree of liquidity found in any market is most commonly assessed in terms of tightness, depth, and resiliency. Tightness refers to the relative divergence of trade prices from mean prices reflected in bid-ask spreads or the market’s capacity to align supply and demand at minimal cost. Depth reflects the number of trades or the size of trades that can be completed without impacting current prices. Alternatively, depth may be reflected in the turnover or trading volume in a market, which is a commonly used measure of liquidity. It is generally assumed that tightness and depth are positively correlated with narrower spreads found in more actively traded markets. A third common measure of market liquidity is resiliency or the speed at which prices and order volume return to their equilibrium values subsequent to a large trade.

The determinants of market liquidity in any one market can result from the interaction of various factors including financial instrument design, market microstructure, and the behavior of market participants. The design of financial instruments determines their substitutability, which, if high, may result in higher concentration and measured liquidity in one among the alternatives. Such preferences would then induce investors preferring greater liquidity to also invest in that one financial product. Alternatively, substitutability may lead to greater liquidity for all as one substitutable product may more easily serve as a hedge for another.

Market microstructure can also significantly influence market liquidity. One distinction is between trade execution systems: auction-agency or order-driven markets, such as most organized stock exchanges, and quote-driven or dealer markets, such as the foreign exchange market. Price discovery is believed to be enhanced by the former while the latter allows faster execution of trades but reserves for the dealer a monopoly on information about order flow. Such systems vary around the world and are not necessarily determined by the particular financial instrument traded. They are often the result of historical or institutional legacy. In general, market liquidity is enhanced by the existence of competitive trading structures for market makers and participants. For example, the ability to trade a stock on both an organized exchange and over-the-counter (OTC) or on more than one exchange increases the market liquidity for the stock. Competition between exchanges and markets can increase liquidity by increasing trading efficiency. Other microstructure elements can also affect market liquidity. For example, lower transaction costs and the standardization of trading and settlement practices appear to increase market liquidity. Finally, market participant behavior and composition are other factors affecting market liquidity. An increase in investors’ risk aversion reduces it as does the loss of confidence in their forecasts of future prices. Greater heterogeneity of financial market participants, including cross-border participants, increases liquidity through the enhanced prospect of matching buyers and sellers in the market.

Although greater market liquidity is generally considered a public and private good, there is also the possibility of excess liquidity. Financial crises often follow the collapse of asset price bubbles that are generally believed to be created by excess liquidity resulting from the expansion of credit in one or more markets. Following the collapse of a bubble, credit tightens as the value of bank assets falls and liquidity may evaporate in markets throughout the financial system. Ultimately, the liquidity of financial instruments in a market depends upon the confidence of market participants in their ability to assess their value and trade them at will. Excessive confidence can lead to excess liquidity and asset bubbles. The loss of investor confidence can lead to illiquidity and the collapse of markets. In such cases financial markets look to central banks to restore liquidity.

Bibliography:

Allen and D. Gale, “An Introduction to Financial Crises,” Wharton Financial Institutions Center, Working Paper No. 07-20 (2007);
Bank for International Settlements, Market Liquidity: Research Findings and Selected Policy Implications (1999);
Fleming, “Measuring Treasury Market Liquidity,” Federal Reserve Bank of New York Economic Policy Review (2003);
Kristian Hartelius, Kenichiro Kashiwase, and Laura E. Kodres, Emerging Market Spread Compression: Is It Real or Is It Liquidity? (International Monetary Fund, Monetary and Capital Markets Department, 2008);
Holmström and J. Tirole, “Market Liquidity and Performance Monitoring,” Journal of Political Economy (1993);
Jennifer Huang and Jiang Wang, Market Liquidity, Asset Prices and Welfare (National Bureau of Economic Research, 2008);
Kyle, “Continuous Auctions and Insider Trading,” Econometrica (1985);
Marès, “Market Liquidity and the Role of Public Policy,” BIS Papers No. 12 (2002);
Josephine Berry Slater, Living in a Bubble: Credit, Debt & Crisis (Mute Pub, 2007).

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