Liquidity is the name of the game as far as exchanges are concerned. The L word is what matters; it is the reason why companies seek out certain exchanges for listings and why investors and intermediaries flock to those exchanges to invest and trade.
A virtuous cycle of sorts is at play. Higher liquidity levels lead to higher valuations of listed securities. This, in turn, pulls in more listings, which attract more investors and intermediaries, fuelling yet higher liquidity levels. Without liquidity, an exchange would wither away and many a good IPO broke because shares were listed on a market bereft of liquidity.
A simple definition of liquidity is the ability of investors to execute large transactions quickly and without impacting the prices of the securities they are transacting in.
Two measures of liquidity stand out: traded value relative to market capitalization; and, traded value relative to GDP. From an economist’s point of view, these measures were found to be positively and significantly correlated with rates of economic growth, capital accumulation and productivity gains in a given terrain.
This is not surprising. Projects with high projected IRRs need long term capital. Liquid exchanges and stock markets allow investors to trade ownership in such projects. This encourages the continued supply of long term capital as liquid markets provide investors with viable exit alternatives.
The microstructure of an exchange can hinder or facilitate liquidity and three measures are utilized in this respect: Tightness (the degree to which transaction prices diverge from mid-market prices, measured by the bid-ask spread); Depth (trade volumes that can take place without impacting current prices, sometimes measured by size of order books); and, Resiliency (the speed with which price changes resulting from trades are dissipated).
Liquidity tends to be concentrated in certain markets or securities, often at the expense of others. It also has legs and runs away when conditions warrant.
Liquidity wars are well underway in Europe and the United States. Established exchanges and alternative trading platforms are competing with one another and hardly a month goes by without a statement from an exchange or trading venue on how it intends to compete; a euphemism for its plans to aggregate liquidity, usually at the expense of competitors.
The ability to take liquidity away from a competitor is impacted by several factors. Pricing and transaction costs are important but are by no means the only variables. Smaller transaction costs may enable one market to accumulate liquidity but the impact of competitive pricing varies according to specific market conditions, which include what is being traded and the transparency of market data.
The impact of transparency on liquidity is not easy to measure. It depends on the ability of all market participants to equally observe different kinds of trade and market related information. And regulatory moves can add a layer of complexity to this ability.
In addition to price and trade information transparency issues, liquidity amalgamation can benefit from standardized clearing and settlement procedures. It also helps to have a diversified group of market participants (geographically and sectorally). Some exchanges emphasize a core market for certain assets and focus on developing it. The resulting liquidity in the core helps liquidity in any secondary tiers. And finally, of course, there is market making which is the topic of another Stock Market Note!
But however technical we get when talking about liquidity, the human factor is always there. At times, the behavior of market participants is impacted by self-fulfilling prophecies; liquidity may be present or absent simply because investors and traders expect it to be present or absent. Additionally, how market participants behave depends on how sensitive they are to short-term price movements, the level of risk they can stomach at a given point in time, and how sure they are of their own market predictions.
Competitive pressures unleashed by market forces and such regulatory moves as MiFID and Regulation D are good. However, it should be noted that a fine line exists between ensuring competition between liquidity pools and an over-fragmented environment which may actually reduce liquidity for a given security or market.
