Quantitative Finance > Trading and Market Microstructure
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Create account Login Subscribe. Matteo Regesta, Alessandro Tentori 04 October Market liquidity is all about smooth and rapid executions of large transactions. Q liquid markets why is it hard to keep big markets liquid?
Market liquidity is often defined in terms of the smooth and rapid execution of large transactions. However, there is no guarantee that large and frequently trading markets will stay liquid under all circumstances. For example, trade transparency rules require the regulator to provide a robust model of bond liquidity. This matters not only for end investors, but also for market makers who ultimately provide liquidity to markets. Hedging liquidity risk is always problematic and often even impossible.
Liquidity risk gives birth to one of the paradoxes of regulation in fixed-income markets — the aim for more transparency might depress market liquidity and distort the price-finding process, with the ultimate collateral cost of reducing transparency. Fixed-income markets mainly differ from equity markets in terms of the number of securities per issuer and the resulting fragmentation and bifurcation — the splitting in two — of liquidity.
Measuring liquidity in markets for liquid fixed-income securities is not straightforward. Based on various measures, Regesta and Tentori suggest that liquidity has been on a declining trend for some time. For example, both traded volumes in Eurex fixed-income products and the number of contracts per trade have been on a long-term declining trend Figure 1.
In fact, a more granular analysis of the limit-order book for Bund futures suggests that top-price level liquidity has declined significantly during the course of this q liquid markets Figure 3. Data shows the average q liquid markets sizes for Bund futures in number of lots q liquid markets from the exchange at the top price level, i.
Q liquid markets decline in market liquidity creates major challenges not just for bond market participants short term q liquid markets also for the financing structure of the economy long term. We find that several forces might be having a negative effect on liquidity conditions:. Furthermore, future changes in existing risk-management rules might trigger additional pressure at the microstructure level of European government bond markets.
For example, we should not assume that sovereign debt will always be q liquid markets as q liquid markets zero-risk weighted asset, as is the case under Basel III regulation. The liquidity transformation function of the asset management industry could become a systemic issue in case of large and fast redemptions. In theory, investors who invest in mutual q liquid markets have also purchased an embedded liquidity option — the fund manager has a skew towards investing in less liquid instruments, while at the same time providing quasi-ready q liquid markets to his investors.
So far, so good, but why should we be concerned about liquidity issues? Liquidity is essential for the functioning of markets. A simple example illustrates the point Tentori In the case of sovereign debt, q liquid markets stylised process can be described as new risk being created regularly by sovereign debt management offices — the risk is absorbed by market makers and then smoothly distributed to end investors. In order to process both new and existing risk, which is already at historical highs Figure 5market makers rely on customer flows agency model as well as on their risk limits principal model.
The ability to trade liquid instruments is essential for the hedging of large bond flows in a quote-driven market. The social cost of illiquidity should not be underestimated. Theoretical models of the term structure of liquidity are being developed, but in our view we are still far from a full understanding of the price of liquidity in fixed income markets. Also, negative side-effects of illiquidity on policy transmission should be q liquid markets when optimising any given policy strategy.
Fixed-income markets might already be in a negative liquidity trend. Contingency planning should also be an integral part of the preparatory exercise before the introduction of new financial regulation. Liquidity is a latent variable and as such, policymakers are better off making extensive use of soft information and qualitative tools. Market liquidity in liquid markets: Pitfalls and trends Matteo Regesta, Alessandro Tentori 04 October Market liquidity is all about smooth and rapid executions of large transactions.
Finance and growth — beware the measurement. A new set of vulnerability indicators. Measuring liquidity in European government bond markets Measuring liquidity in markets for liquid fixed-income securities is not straightforward.
Declining volumes on markets for fixed income futures Source: Measuring market depth Note: Analysing the drivers of market liquidity A decline in market liquidity creates major challenges not just for bond market participants short term but also for the financing structure of the economy long term. We find that several forces might be having a negative effect on liquidity conditions: According to the UK Department for Business, Innovation and Skills, we q liquid markets already seeing the negative effects of regulation on fixed-income markets, that is, a declining allocation of capital to market-making activities and a reduction of inventories Fender and Lewrick Rapid increase in assets managed by mutual funds Source: The micro-structure of bond markets So far, so good, but why should we be concerned about liquidity issues?
Evolution of the market risk of European government bonds Source: Conclusions and policy recommendations The social cost of illiquidity should not be underestimated. Monetary policymakers should take into account the illiquidity bias when extracting market-based information. Regulators should thoroughly asses the full range of positive and negative effects of new rules q liquid markets the micro-structure of markets. There is no q liquid markets indicator of market liquidity.
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