.jpg)
The ability to accurately measure liquidity in financial markets is crucial both for traders who want to formulate an optimal execution strategy and for regulators who wish to assess the quality of operation of financial markets. However, recent developments in market structure have made this measurement task difficult. First, the fragmentation of modern equity markets and the use of multiple trading venues by market participants means that to measure liquidity one must aggregate across many venues and data feeds to obtain a ‘consolidated’ view of the market, while to execute efficiently requires the use of a ‘smart order router’ (see, for example, Foucault and Menkveld, 2008). Second, though, the same market developments have led to changes in order submission strategy by traders which imply that ‘consolidated’ liquidity (measured as the simple aggregate of shares available across all trading venues) is likely to be an overstatement of the actual liquidity that an average trader can access. We refer to the difference between measured liquidity and tradeable liquidity as ‘Ghost Liquidity’ (GL).
To understand GL, consider a simple scenario in which all participants involved in trading a stock have access to two venues. An investor who wishes to passively buy a unit of the stock might place a limit buy order on one of the two venues. She then executes if a matching market sell arrives at this venue. However, she misses out on trading opportunities if market sells are arriving at the other venue. Thus, to maximize her chances of execution, she is incentivized to place similar limit buy orders on both venues and intends, when one of the orders has executed, to cancel the other. It is this order duplication that is at the heart of what we call GL. Of course, order duplication is not without risk. If both of our trader’s orders are hit simultaneously, she will have executed too great a quantity.
Click here for full details.
