Welcome to the third blog in our series on liquidity. If you haven’t done so already, please read our previous pieces: What is liquidity? and What is a liquidity provider? In those blogs, we addressed what constitutes liquidity and how it is provided.
We have touched on how diverse liquidity providers, using diversified strategies, are critical to facilitating risk transfer. What do we mean by diversified strategies? As we said in our last blog, business models can range from passive to active, and holding periods can vary from seconds to hours to weeks or longer.
There are just as many types of strategies at work. Firms can take part in correlation trades that rely on a consistent relationship between the prices of different assets. In spread trading, market participants take both long and short positions in related contracts. Directional trading strategies attempt to predict future market movements. Some market participants make markets by providing two-sided prices at which they are willing to buy and sell.
All of these strategies contribute to liquidity. There are occasionally some questions about whether principal trading firms (PTFs) provide “valuable” liquidity. This question has a flawed premise, however; it presumes that liquidity has a quality. We can evaluate the degree of liquidity in a market, but if liquidity is present, we can’t say that it is somehow good or bad. Liquidity is a binary variable—it is either present or it isn’t. Take for example, market open. Diverse market participants begin to submit resting orders. These resting orders contribute to market depth. As more and more orders come in and market participants begin to express different points of view, we expect transactions to start occurring.
“But some liquidity is short lived!” according to skeptics. This, again, overlooks the fact that liquidity is not a qualitative metric. Whether or not one party holds the asset after the trade is irrelevant. Many PTFs, for instance, manage inventory and offset risk through hedging. The liquidity they provide allows for transactions among market participants, regardless of how long they inventory that asset afterwards.
There is also sometimes confusion about price movement in liquid markets. Healthy, liquid, efficient markets react to new information with price changes. So, for instance, news about a product launch may influence that company’s stock price, just as a large sell order may influence the price of a futures contract. This is not an example of illiquidity, but rather of price discovery. Price discovery is an important function of our markets and price changes based on new information are inherent to this process.
During unusual market events where there are periods of extreme volatility, different types of market participants behave differently. This is true of liquidity providers as well. A joint government staff report on volatility in Treasury markets noted this difference in 2015: “In general, the analysis shows that the spike in trading volume and volatility coincided with a sizeable reduction in the depth of orders provided by PTFs and with the posting of much wider bid-ask spreads by bank-dealers. In addition, for brief periods, bank-dealers were absent from the offer side of the cash market.” (p. 25)
Both bank-dealers and PTFs were following rational risk management procedures given the unusual volatility. For PTFs that meant reducing the quantity of orders while still maintaining tight bid-ask spreads. Importantly, PTFs remained in the market, which contributed to continued liquidity.
In our next piece, we’ll discuss how to measure the degree of liquidity in markets and how to optimize market structure to promote liquidity provision. Stay tuned.
