If we wish to know the current health of our markets we need to look no further than understanding its state of liquidity. We will attempt to describe or define liquidity, outlining its value to the state and the individual, and suggest steps to develop our capital market further.
What is Liquidity in capital markets?
How do we define liquidity within the context of capital markets? In simple terms, liquidity is the extent to which assets can be bought or sold quickly and with price stability. Often, liquidity can be quantified by the spread between the bid and ask of an asset and the volume of trade activity for a given time period. Market liquidity is never fixed. It fluctuates relative to the level of interested buyers and sellers at any time. Liquidity is also a measure of transactional risk related to the particular asset. If you purchase a home or piece of real estate you are subject to more transactional price risk then a large cap listed security. Price discovery is more difficult with real estate as there are fewer buyers or sellers and there is no public facility publishing reliable bids and offers for a specific piece of real estate. If market forces occur to change asset values an investor can quickly alter their holding in this asset while holding real estate provides few options to change risk exposure related to this asset. Conversely, a listed security has published bids and offers during exchange hours with associated volume. Thus, the risk of purchasing or selling a security is essentially displayed through the spread between the best bid and best offer and transactional risk is substantially lower.
Why do we care?
On a macro scale assessing liquidity across many asset classes is essential when judging the health and stability of the overall economy. What is the liquidity status of Fixed Income instruments and Treasuries? How easy is it to access credit markets? Is the commercial and residential real estate market active? Is our stock market volume stable and robust? Deriving and sustaining liquidity is a complex question as it is impacted through both market structure and external economic events on different asset classes which do not behave or react similarly to market forces.
We also care about liquidity as it affects returns for investors, the cost of raising capital for corporations, governments and other borrowers. Additionally, if markets are illiquid, they become more volatile which has multiple adverse outcomes. Higher interest rates required for lenders, higher rates of returns required for investors and higher likelihood of financial instability in markets.
Consequently, as an individual we care because it impacts the risk and cost to invest in capital markets. As a state we understand illiquidity increases the cost and limits access to credit markets which underly the growth mechanism of our economy.
What do we do?
The bulk of this discussion addresses how market microstructure and mechanics will impact liquidity and help create a more stable liquidity engine for capital markets. Healthy capital markets are essential for domestic and global investment in our economy and benefit the state and its citizens with enhanced opportunity to grow and the ability to sustain recessions with less impact and faster recoveries.
Liquidity begets liquidity. This is a primary principle that is the catalyst for market growth and viability. It can be a conundrum as you require what you do not have to produce what you need but there are tools and methods to create the environment required to grow transactional activity. Let us segment market development into stages. Early, mid-stage and mature. Each stage requires unique attention to grow liquidity.
Early stage markets must educate and attract local investors. These markets should be electronic so they are easy to interact with in scale to the local population. Regulations and tax laws should motivate local investment through incentives.
Mid stage can focus on listing services to the corporate community acting as a viable alternative to debt financing or private equity. Attention toward attracting a diverse mix of investors is imperative to creating liquidity. Investors in listed equities with similar timeframes, objectives, capital, and return objectives will not create liquidity but one block of similar transactional behavior. The lack of investor diversity will expose liquidity shortfalls in adverse market or economic conditions.
A basic example of diversity of investors can be illustrated between the retail investor and the market maker. Investment time horizons are vastly different between these two investors. A retail investor will likely hold a security from weeks to years dependent upon their investment expectations. A market maker may hold a position between seconds to possibly days. The risk profile and return expectations of these holdings are notably different. Consequently, a market maker will thrive when they can buy or sell a security at a spread that is much smaller than where another retail investor may buy or sell as their price targets are considerably smaller. Similarly, a market maker must have a low transaction cost per trade to enable return on small price move. A market maker may hedge against another financial instrument like an index or it may offset its underlying market risk by hedging against another security. They are experts at managing risk and receive a small premium for taking the risk to provide a bid and offer versus the random chance that another retail investor may be willing to buy a security at a level another retail investor wishes to sell. Market makers receive a small premium and look to make these transactions in a large scale. The diversity between the retail investor and market maker creates value for both groups. The market maker will provide tighter bid ask spreads for a security lowering the transactional cost of the retail investor for entering and exiting their security investment. The market maker can make a small profit providing the liquidity to the retail investor as their time frame is short and can benefit on small price fluctuations due to lower cost of transactions.
Other diverse investor types can also include Domestic Institutional investors like Pension funds or Investment funds. These actors represent a large group of investor interests. Their investment timeframe is long term and fundamentally derived in nature. These Investors require liquidity since they must move a large amount of capital through the market and are sensitive that transactional costs do not erode significantly against their investment returns. In developing markets you may find smaller capitalized securities are more illiquid and will not qualify for Pension fund investment due to higher transactional costs and thus the company’s financial performance is bypassed as the cost to purchase and eventually sell that security is prohibitive. A firm may perform well and the decision to buy the security at 25 and sell at 35 can be a sound decision but not viable if the investment firm wishes to move 5 million dollars of that security and incur price erosion of 1 dollar per side. The Investor must essentially pay 2 dollars of a 10 dollar successful investment target if they wish to invest in this security. Add taxes and fees and an Investor must make excellent decisions over and over to yield a return to meet their client’s objectives. Consequently, not all listed securities will benefit from the exchange listed market equally if they are not liquid.
Here again, a market making entity can resolve this issue through offering short term liquidity and tighter spreads enabling investment into securities not previously viable. The market maker has the ability to spread large volume investor orders into other assets to manage short term holding risks and then unwind these spreads over time at a profit. There is no conflict of interest as the market maker is driven by small profits in short time frames while the Domestic Institutional investor has much longer time frames and can incur small transactional costs and enable more investment choices.
Current State of Equity market.
Our market has passed the early stages of development and would be well served to invest in technologies that will promote and enhance liquidity for listed securities. These technologies can be segmented into various components but are interconnected. Connectivity, DMA (Direct Market Access), Execution algorithms, and Crossing systems like an ATS(Alternative Trading System).
The move to enhanced electronic trading will require co location capabilities with a careful thought to parity and server access to the exchange among participants. All participants should have equal access to the exchange matching engine and ensure there are no time advantages to the exchange.
Execution algorithms will be useful today, and in the future, when volumes and participation increase. These algorithms facilitate moving larger orders through the current liquidity state of the market with the least amount of price impact. Investors will benefit by managing order size revealed to the market at any given time and exercising passive order entry or aggressive order entry when the price activity commands. When large orders from institutions need to be executed much of this order can be managed on the exchange versus over the counter. The order will be split into many small pieces and executed over time. The exchange sees more transactions on their venue and the public benefits with the ability to participate in the order versus it being crossed away from the exchange. The end result is more liquidity in the market with diverse investors and more order flow/transactions.
DMA or Direct market Access can be simplistically a connection from a colocation facility to the exchange engine, typically over a fix protocol. These are governed by a sponsoring broker dealer and the exchange or regulatory body. This is the infrastructure a market maker would utilize to ensure fast and reliable access to the markets they provide liquidity. This technology will also be of interest to algorithmic trading firms or systematic traders as well. We must provide this environment to open the door for these strategic diverse participants as they will be the foundation of adding and growing more diverse liquidity in our markets.
Finally, opening the market to an ATS can be valuable as the market matures further. An ATS is a special purpose facility that attracts specific investors or market participants. Consider the current over the counter market whereby large orders are quoted and traded. In the present environment these orders are executed outside the best bid or best offer on the exchange because the investor prefers to execute at one price and with little or no transparency, known as information leakage. These dark or semi dark markets serve a value to specific institutional investors as they prefer that their buying and selling activity is not public knowledge and to reduce the ability to front run their needs to buy or sell a specific security. Ultimately, we want to incorporate the dark or semi dark ATS within the exchange system. This is simply done through smart routing and connectivity that result in ISOs (Intermarket Sweep Orders). If a large buy order is executed on the dark market it must satisfy all orders on the exchange order book that are offered better than the price they intend to execute in the dark ATS. The result is a better execution for the institution using the ATS, less information leakage for the institution, more participation and volume for the exchange and more liquidity for the market and public.
When looking at the stages of market development we can focus upon Co location and DMA as mid stage development efforts while execution algorithms and ATS serve more advanced needs of the equity capital market.
We are clearly at the next or mid stage level of capital market development and would be well served to foster these advancements so liquidity can be enhanced, transparency and investor interests are better served and we can attract not only domestic investment but global investment into our economy.
It appears the most impactive step is to adopt a market maker system of liquidity within the exchange. There are a few options or variations that can be implemented to encourage or imbed market making into the exchange marketplace.
In general market makers would be designated or nominated after meeting specific exchange based criteria. This may have a capital requirement as well as regulatory oversight requirements. These market makers will help ensure an orderly market, reduce bid ask spreads and in exchange for this they are compensated through returns from trading the bid ask spread or and including fee rebates. The rebate exchange model provides a small per share payment for providing liquidity and a small per share charge for taking liquidity. Since the market maker is naturally providing liquidity these rebates can be a source of compensation.
Some exchanges have adopted a centralized market making schema whereby one market maker exists for a specific security. The market maker is an expert in understanding the specific securities they cover and often hold inventory of that security. The market maker will benefit by understanding where all bids and offers exist for that security at a given time and is expected to provide liquidity when there is a lack of bids or offers at certain price levels or market activity. This type of market making is also considered to be less transparent as only one participant has this type of information access.
A decentralized market making system would designate a group of market makers for each security creating competition between the groups and ultimately tighter bid ask spreads.
Finally, a quote driven system would require market makers who consistently provide two way markets and at some required spread.
Rule changes or exceptions for market makers are required as their trade and profit dynamics are substantially different than other participants. Their cost of transaction must be extremely low as most of their transactions will be for a small gain, loss or scratch. They must have the ability to short securities without the requirement to locate the stock for borrowing. Rules such as these are required so bid ask spreads can be reduced and inherently add liquidity for the public.
Other impactive measures can be enacted to bring participants to the equity market. The most impactive would be tax benefits for both Institutional investors or pension funds and an elimination of any transaction tax on exchange participants as this again directly widens the spread between the bid and offer and increases the cost just to participate.
The benefits will outweigh the cost through broader participation in equity markets, lower cost of capital to corporations as the equity market becomes a viable and more compelling market to raise capital, and finally a more stable and orderly market for both domestic and global investors.
A series of small changes can make a large impact in our markets. If we are to attract both domestic and global investment, we must present a liquid market to access these assets. Small steps like enabling the environment for market makers in our equity market will attract more diverse investors and consequently lower transactional costs related to investment. Liquidity begets liquidity and we need a catalyst to grow our market’s viability.