Ask any trader what they care about most and the thing that most stands out is the bid-ask spread. Spreads can be kept low because of liquidity. If the market is liquid spreads can be narrow. The less liquid the market, the wider the spread.

Since the financial crisis there have been concerns that liquidity has reduced. Regulation has crimped the ability of banks to trade, reducing market liquidity. At the same time, technology has exerted an unprecedented effect on liquidity. Flash events seem to be happening more often.

It’s a problem that Federal Reserve vice chair Stanley Fischer addressed in a recent speech. His overall assessment is that liquidity is fine most of the time. And whatever might be causing a slight drop now and again is too complex to pin to one factor, for instance the Volcker Rule.

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Primary Dealers

 

Fed data shows primary dealers' inventories of fixed-income securities have fallen significantly since the Lehman Brothers failure, from about $1.3 trillion to about $700 billion. This could be a regulatory thing – the Volcker rule for example, which prohibits banks from proprietary trading.

Fischer notes that this may curb the “willingness or capacity of the primary dealers to make markets--which may in turn lead to lower liquidity”. He added: “However, whether markets are in fact less liquid depends on both the degree to which the decrease in primary dealers' inventories affects their willingness to provide liquidity and the extent to which nonbank firms such as hedge funds and insurance companies fill any lost market-making capacity.”

Declining average trade sizes are also a concern (again focusing on the bond market). But overall there seems to be no problem with trading volumes. Volume is an important indicator because if transaction costs are high (wide bid-ask spreads), it is likely to deter activity.

Data from the corporate bond market (which mirrors the Treasury and equity markets) seems to show volumes on the rise – corporate bond volumes were $12bn a day in 2006, down to $8bn a day during the height of the crisis and now are up to $19bn a day.

Flash Events

 

Are flash events more common? “Flash events may be more frequent today, and the dynamics of a system with frequent flash events are likely to become complicated,” Fischer said.

We’ve seen quite a number in the last two years – a sharp move in Treasury prices on October 15, 2014; a wild gyration in the euro-dollar exchange rate on March 18, 2015; and the swing in sterling on October 7, 2016 – the flash crash that the pound is still recovering from. Researchers at the Federal Reserve Bank of New York believe volatility spikes and sudden declines in liquidity are more frequent in both Treasury and equity markets. The Commodity Futures Trading Commission also thinks flash events are more common.

“Market participants suggest that the rapid growth in high-frequency trading in equity, foreign exchange, and U.S. Treasury markets, along with broader concerns about less resilient liquidity, potentially explains these flash events,” said Fischer. A 2014 report into the events of October 15, 2014, however, said there is no single factor that caused the sharp swing in Treasury prices.

Trading Costs

 

How much it costs to trade is a key indicator of market liquidity. “Even though flash events appear to be more common, it is certainly too soon to declare that a broad reduction in market liquidity has occurred,” Fischer said.

In fact he was able to argue that “transaction costs seem to suggest liquidity has improved”.

He added: “Overall, liquidity is adequate by most measures, in most markets, and most of the time.

Bid-ask spreads and price-impact measures point toward liquidity that is good by historical standards, and we have not observed declines in market liquidity in recent episodes of high market volatility. Nevertheless, the market structure is changing, and trades in certain situations and in certain market segments might have become more costly.”

HFT

 

It wouldn’t right to discuss liquidity without discussing high frequency trading. There are many conflicting views on what HFT means for market liquidity, but the pervading view is that HFTs offer useless liquidity in normal times but pull the rug out from under the market when things go wild.

As described by Michael Lewis in Flash Boys and elsewhere, HFTs place and then cancel huge volumes of orders to create ‘phantom liquidity’. This liquidity is an illusion and it comes at the expense of ordinary traders, so the argument goes.

However one academic paper from a group of four professors, including Jonathan Brogaard at the University of Washington, argues that HFTs contribute liquidity during what they call extreme price movements (EPMs), helping to stabilise the market. But in normal times they require more liquidity than they provide. And even in stress events the HFTs only boost liquidity for single stocks, not the market as a whole. The good news is that they argue that HFTs do not create flash events.

They said: “We find that on average HFTs provide liquidity during EPMs by absorbing imbalances created by non-high frequency traders (nHFTs). Yet HFT liquidity provision is limited to EPMs in single stocks. When several stocks experience simultaneous EPMs, HFTs do not supply liquidity. There is little evidence of HFTs causing EPMs.”

Moreover the phantom liquidity argument is also being refuted. Jesse Blocher from Vanderbilt University argues in a new paper that this too is a mirage.

“Phantom liquidity only can really be a problem if those who cannot get good execution find the price moving against them when they try to trade…We do not find that in our data,” he writes in the paper published in the Journal of Trading.

Arguments over HFTs will persist, but there seems to be consensus that despite a number of pressures, market liquidity remains reliable, even if flash events may become a little more common.