Friction in Financial Markets - Measuring and Examining the Liquidity of Financial Assets

        However, as stated by others like Kyle (1985), the spread can be viewed in an informational sense, as “the value of information lost to timelier or better informed traders”, or as “a measure of the redistribution of wealth from some traders to others.” (Stoll, 2000) One theory that has stemmed from this informational approach to friction, put forward by writers such as Copeland and Galai (1983), argues that by posting quotes, market makers grant options to the rest of the market, so the spread is simply the cost of the option.

        It is the more widespread opinion that “market makers are aware that some investors could be trading on superior information and thus increase the spread in order to offset the losses incurred from trading with these informed traders.” (J. Board et al, 2002) In this sense, asymmetric information is a major component influencing the size of the bid-ask spread, which can be reduced by ensuring greater transparency.

        Whilst we can say that real frictions do not have a permanent impact on price level, as they are compensated for by trading gains earned from the bid-ask bounce, informational frictions do. Therein lays the basis for Roll’s framework (1984) for evaluating trading friction. The sources of the spread can be distinguished by comparatively examining the short-term price changes in stocks with their spreads.

        Other empirical measures of total friction, such as the quoted and effective half-spreads, are static. Stoll himself produced a new, more dynamic way of measuring real friction, the traded half-spread. This enables us to approximate informational friction over the long-term.

Further reflection on liquidity and its effect on friction

        Of course, the primary sources of real friction are essentially the costs of liquidity in most markets due to the presence of intermediaries: order processing costs and inventory holding risk.  When the volume of trading increases, though, the expected length of the inventory holding period decreases also. (J. Board et al, 2002) Therefore greater liquidity has the effect of reducing trading friction.

Equally, larger orders, being more difficult to accommodate, lead to greater inventory imbalances, and thus widen spreads, as suggested by the model of Amihud and Mendelson (1980).

Other writers, such as Ho and Macris (1985), argue that greater market depth can lead to wider spreads because dealers’ fixed costs (including the opportunity costs of their time) rise, despite the fact that increased competition between dealers should dissipate market power.

Indeed, if we examine Copeland and Galai’s free-option hypothesis from a market-wide perspective, as J. Board et al argue, it seems that dealers are less willing to revise quotes so as to avoid writing free options, and this decrease in competition effectively leads to wider spreads. A lack of liquidity at the market opening can also lead to wider spreads. 

Thus any study of friction is fundamentally linked to the notion of liquidity. Both go hand in hand, in that the more liquid an asset is, the lesser the friction inherent in the disposal process. We should not underestimate the importance of friction therefore in deciding market policy, and its effect on asset pricing.

What are the factors determining the liquidity of an asset?

Illustrate some of the concepts affecting liquidity using quoted bid-ask spreads from different markets.

“Time is the essence of liquidity; the more quickly an asset can be converted into cash at market value, the greater is liquidity”

Herring R.J., Innovations to enhance liquidity: implications for systematic risk, 1992

Liquidity is “a bundle of measurable properties.” (Marschak, 1938) Though, it all boils down to supply, demand and market equilibrium.  A liquid asset is so because it can be traded immediately at the prevailing market price. There are no barriers preventing its exchange. Thus, it could be regarded as a form of currency in an inflationless economy, that nobody has any qualms about accepting. The person acquiring the currency knows that it can be exchanged again without hindrance because there are an infinite number of traders willing to accept it, knows that it will cost him nothing to exchange it, that no intermediary will profit from any exchange and that it has a given value, which it will retain, come hell or high water.

In financial markets, there are no certainties, there are only risks. Sure things, unequivocally, do not exist. Even bonds are subject to changes in rates of interest and inflation. Yet, there are ways of designing markets to make them more liquid, ways of reducing costs and even some of the uncertainty. Knowing what affects liquidity can lead us in the right direction.

Liquidity as a function of the frequency of offers

No matter where an asset is traded, the liquidity of the asset is, largely, determined by the number of traders in the market. More traders ensure greater demand for a given supply. If you hold an asset for which you will find difficulty in finding a buyer, the asset is relatively illiquid.

We must also state that the frequency of offers is itself a function of other variables. Firstly, take capitalisation. If an organisation issues billions of shares, it is, generally, more likely that it will be easy to find a buyer for or seller of the shares.

Let’s take one of the largest organisations in the world; General Electric Co. It is one of the largest entities quoted on the NYSE. One should not be surprised therefore, that at 4.10 pm on the fifth of November, the spread on the shares was just 0.06$. 

Another major determinant of liquidity is the extent to which shares in an organisation, or in the market as a whole, are traded. On average over the course of 3 months, nearly 19 million GE shares are traded per day. The number of trades concluded and the number of shares that change hands regularly gives a good indication of how liquid stocks are. On the 6th of November, more than 20m shares in Microsoft were traded on the Dow Jones Industrial Average. Its bid-ask spread reflected the buoyancy in its trading.Generally, brisk trading translates to lower bid-ask spreads.

Good comparisons can usually be made between cross-listed securities, though not all are perfect substitutes. AIB shares are listed on the NYSE in the form of American Depository Receipts (ADR), for example. With a higher volume of trading of AIB shares in Dublin (and London), the spread tends to be wider on the NYSE.

Volatility, predictability, marketability

The number of buyers willing to acquire your asset is also decided by its attributes, like the variance of returns from the asset. Financial assets are valued by the cash flows that the holder is expected to receive in the future, though these revenues may be uncertain. Fixed-income securities can be valued more easily than irregular dividend paying stocks, and highly-rated instruments such as government bonds are regarded as gilt-edged, so they tend to be more liquid than volatile growth stocks, for example. Lippman and McCall allege that an asset is only liquid if it can be sold “quickly, at a predictable price”.  Shorter-term securities, like T-bills are more liquid, because the buyer must not wait long before his asset matures.

This leads us to question the effect of interest rate changes on liquidity. From a purely economic stance, ceteris paribus, lower rates increase liquidity. So one would expect November 6th’s interest rate rise in Great Britain to widen spreads, but of course, so many other factors can influence prices as well, like the quality of the asset itself.  

Equally, volatility, on a market-wide scale, can have disastrous consequences for liquidity. The perfect example is that of Black Monday, October 19th 1987, one of the single most disastrous days in stock market history, when the S&P 500 fell over 20%. As fears of losses escalated, risk-averse traders sold outrageously, ballooning bid-ask spreads.  Trading was halted in some shares. Liquidity collapsed. People were selling at substantially reduced prices, in an effort to cover themselves from further losses. (Rubinstein, 1998)

Yet, also, how will the sale take place? It could also be argued that if price negotiation were popular, spreads would be wide as dealers look for price improvements. (J. Board et al, 2002) That aside, when trying to find a buyer, price is essential. Higher priced assets require more thought, more deliberation. Even the credit-worthiness of the buyer could be taken into account.

 

Liquidity as a function of impediments to title

transfer and the cost of holding the asset

There are certain things that affect the liquidity of all financial assets quoted in an exchange. These are factors that are directly linked to the exchange mechanism itself and other imposed negativities such as taxation, that deter investors.

Trading Costs, Holding Costs and Taxation

Order processing costs are frictions that impede the process of trading though they essentially ensure its completion. As J. Board (2002) affirms, “the relative costs of trading on an exchange are likely to determine where the bulk of trading volume ultimately resides.”  Equally, Madhavan’s theoretical comparison of trading of a cross-listed security (2000), indicated that if order costs were a function of volume, in the long-run, trading would be consolidated in the exchange with the lowest per unit trading costs.

Inventory costs for dealers represent price risk and the costs of financing the inventory. Longer holding periods, induced by trade imbalances, increase costs such as that of the opportunity of money tied up in the inventory. However, brisker trading brings down holding period times, improving liquidity and the perception of settlement risk. (Board et al, 2002)

One of the main reasons cited for the poor performance and relative illiquidity of the CAC 40 is the draconian fiscal policy enforced by the French government. The indirect effect on liquidity should not be overlooked, and the recent decision to no longer tax dividends in the U.S. is a major development.

Market Structure and Trading Platform

        The studies conducted in the recent past by people such as Huang and Stoll (1996) have led many others to question many existing trading practices. Most criticism has been centred on dealer markets, where internalisation and preferencing can apparently lead to poorer execution and collusion, increasing spread sizes.

Wang (1999) was another to examine bid-ask spreads for futures on the SFE on the day-trading open outcry and evening screen based systems. His evidence hinted that higher volatility had twice the effect on spreads on the open-outcry system.

Transparency is another contentious area. When there is more information available on quotes, a significant contribution should be made to the provision of liquidity to the market. (Franke & Hess, 1996)

An interesting 1994 publication from the British office of fair trading questioned why market makers “were so vehement in their demands for a delay” in publicising large trades when the research showed that while large trades did affect prices permanently, the delay in their announcement did not. They concluded that market makers were using the delay to improve their positions.

Another study by Franke & Hess (1996), which analysed the values of German long-term bond contracts cross-listed on separate exchanges, illustrated that liquidity was reduced in periods of higher volatility on the DTB, as opposed to the LIFFE.

Concluding Remarks

So, in essence, liquidity is influenced by numerous factors, stretching from trading frictions to fiscal and monetary policy, even social dynamics. Sentiment is, as ever, the greatest underlying pressure exerted on prices. Narrower, thinner markets are illiquid. Fewer offers mean wider spreads, higher volatility and fluctuating prices. The broader the market, the greater the propensity for that market to be liquid.

People react in different ways to new information. In major crises, the perception of information influences how the market copes. If markets are broader, prices will not be as severely affected as they might be, with differing reactions from bulls and bears.

Greater transparency, better access to information and lower trading costs can improve the efficiency of markets. Liquidity is essentially a measure of how well the market functions. By improving liquidity through the eradication of friction, we should be able to strengthen the confidence that holds the fibres of finance together.

Bibliography

Akerlof, G.A., 1970, The Market for Lemons quality uncertainty and the Market mechanism, Quarterly Journal of Economics, pp 488-500.

Amihud, Y. and Mendelson, H., 1986, Asset Pricing and the bid-ask spread, Journal of Financial Economics 17, pp 223-249.

Board J. et al, 2002, Transparency and Fragmentation: Financial Market regulation in a dynamic environment, Palgrave Macmillan, pp 112-131.

British Office of Fair Trading, 1994, Trade publication rules of the London Stock Exchange / a report to the Chancellor of the Exchequer by the Director General of Fair Trading under the Financial Services Act 1986, pp 5-6.

Copeland, Thomas C., and Daniel Galai, 1983, Information effects of the bid-ask spread, Journal of Finance 38, 1457-1469

Dalton, J.M., 1993, How the Stock Market Works, 2nd Edition, New York Institute of Finance.

Demsetz, Harold, 1968, The Cost of Transacting, Quarterly Journal of Economics, 82, pp 33-53.

Franke, G., & Hess, D., 1996,Anonymous Electronic Trading Versus Floor Trading, Research Symposium Proceedings, Chicago Board of Trade, Chicago, pp 101-136.

Grossman, S.J., 1989, The informational Role of Prices, MIT Press, pp 45-72.

Herring, R.J., 1993, Innovations to enhance liquidity: Implications for systematic risk, Weiss centre for international financial research, pp 11-20.

Ho, T. & Macris, R.G. 1985, ‘Dealer market structure and performance’, ch. 3, in Market Making and the Changing Structure of the Securities Industry, eds Y. Amihud, T.S.Y. Ho & R.A. Schwartz, Lexington Books, New York

Huang, R.D. and Stoll, H.R., 1996, Dealer versus Auction Markets: a paired comparison of execution costs on NASDAQ and NYSE, Journal of Financial Economics 41, pp 313-357.

Kyle, A., 1985, Continuous auctions and insider trading, Econometrica 53, pp 1315– 1336.

Madhavan, A. (2000). Market microstructure: A survey. Journal of Financial Markets (3), pp 205–258

Makower, H. & Marschak, J., 1938, Assets, Prices and Monetary Theory, Economica.

Moore, B.J., 1968, An introduction to the theory of finance, London: Collier-Macmillan.

Roll, R., 1984, A simple implicit measure of the effective bid-ask spread in an efficient market, Journal of Finance, 39, pp 1127-39.

Rubinstein, M., 1998, Comments on the 1987 Stock Market Crash: Eleven Years Later, Risks in accumulation products, Society of Actuaries.

Rutterford, J., 1993, Introduction to stock exchange investment, 2nd Edition. Ch. (1)

Shiller, R.J., 1989, Market Volatility, MIT Press. pp 90-110.

Stoll, H.R., 2000, Friction, Journal of Finance, vol. LV, no.4, pp 1479-1514.

Stoll, H.R., 1978, ‘The supply of dealer services in securities markets’, Journal of Finance, vol. 33, pp1133–51.

Wang, P., 1999, Foreign Exchange Market Volatility in Southeast Asia, Asia Pacific Financial Markets 6, pp 235-252.

Website References

finance.yahoo.com

www.microsoft.com

www.google.com

www.bloomberg.net

---