Has Liquidity Deteriorated?

Mr Ritholtz posts an interesting table on liquidity:


I wrote a few posts in October last year on liquidity, and I’d like to pull out some paragraphs here:

In Liquidity in Liquid Markets, I wrote,

Regulations that aim to bring about positive externalities must take into account the reactions of those regulated, and the reactions by themselves may accumulate to incur a much larger social negative externality. Here, the desire for more transparency in the markets reduces liquidity and frustrates any price-finding mechanism present.

It is also of concern that not only the EU markets that may already be in a negative liquidity trend, but the US Treasuries as well. Although the link between liquidity and volatility is still not wholly understood, the resulting phenomenon of illiquidity could be a rise in the volatility of the trading, especially during tail-events.

[…] Liquidity is a positive social externality, an issue that should not be taken for granted. More thinking please.

In Commenting on Martin Wolf and Liquidity, I wrote,

If investors ‘appreciated’ the risks of possible lower liquidity during normal times or tail events and take those into account, this would drive up the risk premia. This is not necessarily a desirable consequence. In other words, a higher ‘insurance’ or liquidity premium demanded by investors would make the market more costly.

As much of a headache it is to model this liquidity premium, it still shapes the yield curve and the fact that liquidity ‘vanishes’ in Mr Wolf’s word, during tail events makes it even more important that we study it.

[…]  As I’ve said before, liquidity is a positive social externality. And the momentum of liquidity can move either way, increasing and decreasing, and this movement is affected by factors such as overly onerous regulations, loss of confidence in the price discovery mechanism, unstable market environment, perception of increased risks and so many more.

It is not that participants are ‘hankering’ after liquidity, but what the market participants have been saying is that they’re observing a change in the trading situation and it is not for the better. Whatever that may have caused it, they are worried about where this is progressing to. Perhaps it is a natural result of the economy, but perhaps there are certain things that exacerbate the situation, and this needs looking into.

The solution is not to wait until panic occurs to mitigate by providing liquidity, but in thinking about the structure and contingencies before it happens.

As an aside, liquidity considerations can even affect our risk-free benchmarks. If there is a possibility of added liquidity risk thrown into the mix, then the comparison and valuation of other assets, especially that of riskier assets would prove to be a murkier exercise.

[…] And as for this sentence, “But it is too fragile and perverse in its effects on incentives to be viewed as a universal feature of our capital markets”, take a step back and think for a moment why an efficient market requires sufficient liquidity.

Here are two other posts on liquidity:

Has U.S. Corporate Bond Market Liquidity Deteriorated?

Is There Ample Liquidity in The Market?

The table at the beginning of the post is taken from a DB report which I would recommend reading in full.


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