Are you asking the right questions?
A comprehensive liquidity measurement framework should be able to address all aspects of liquidity:
Essentially, a firm needs to answer some or all of the following questions when seeking to execute a transaction:
When considering transactions, liquidation horizon (the time to fill the order), or liquidation cost (price slippage from mid market levels) are often the primary focus.
For securities, measures such as the available trading volume and average transaction cost are preferred metrics. Relative measures such as scores also offer a simple way to compare average liquidity profiles between groups of securities. Price volatility is a useful measure to allow the incorporation of market risk.
When evaluating transaction level liquidity, the market for the underlying security has a strong influence on the ease of transaction execution. Executing in more volatile or stressed market conditions generally proves to be more challenging.
There are often additional constraints. As an example, the expected liquidation cost to exit a $10m trade over a 1-day horizon is likely to be more expensive than executing the same trade over a longer time period. Any liquidity model needs to allow flexibility to express both transaction level constraints and assess the impact of different market conditions.
Global regulators specify that firms must actively monitor their market liquidity exposure, with various measures to reflect this.
The plot below shows a probability density function reflecting expected conditional liquidation costs and liquidation horizons for a given transaction volume.
Typical challenges in the market
1. Size of the position €20 million of blue-chip stock might be easier to sell than €10 million amount of mid-cap or small-cap stocks, as the ease of executing my transaction is also a function of the market conditions of the underlying security. Large-cap stocks often have significant market capacity, whilst small-cap stocks exhibit fewer trading opportunities, typically in smaller sizes. 2. Trading method Exchanges help buyers and sellers connect quickly and provide more price transparency. Instruments that trade over-the-counter (OTC) do not offer an indication of pre-trade transparency so often take longer to sell. 3. Type of instrument Bond liquidity can be linked to systemic factor in the market such as interest rates, inflation, and other external conditions. Whilst idiosyncratic, security based factors such as issuer credit risk, coupon rate, and yield-to-maturity can also impact the liquidity of a bond. Each asset class often has factors specific to that product / market which can have a strong influence on the ability to execute a trade. 4. Trade Volume vs Expected Trading Volume High trading volume can often lead to tighter spreads for bonds. However, if the average trading volume is not consistently higher than the size of the position or desired trade volume, then it may be a challenge to exit the position. For traders at banks, broker-dealers, hedge funds, and other firms, the evaluation process based on these conditions can be daunting even in calm markets.
* Bloomberg surveyed over 1,000 financial practitioners around the globe about issues related to liquidity.
How has market liquidity changed over the past year?
Changes in market liquidity can greatly affect a firm’s trading, portfolio management and overall risk and, as things change, businesses must adapt. While no consensus exists within the industry about how market liquidity has changed, firms are still making adjustments to their operating practices to account for perceived changes. For some businesses, that has meant incorporating liquidity risk metrics into their overall risk management framework, increasing liquidity buffers and increasing holding periods for less liquid investments.
Source: 2019 Bloomberg Liquidity Report
