Source: Golden Ten Data
Liquidity is the lifeblood of capital markets, and it refers to the ability to quickly turn an asset into cash without affecting its price. This has never been a concern in the deep and liquid U.S. market before. This is one of the reasons why the U.S. dollar can become the world’s main reserve currency. However, this month the Federal Reserve warned that liquidity was draining from markets and financial stability was under threat.
Liquidity can be measured in a number of ways. In the stock market, average daily volume, market data (how many stocks or contracts are being bid), and market depth (the total number of stocks or contracts below bid and above bid) can all be used as measures. There are a number of reasons for the drop in liquidity, starting with stock market regulations reducing the incentive to display orders, meaning market makers are reluctant to display bid and ask quotes on screen.
According to Jared Dillian, investment strategist at Mauldin Economics, the recent loss of liquidity can be attributed to the Fed’s tightening policy of a series of rate hikes and balance sheet reductions. He reminded not to forget that in the early days of the epidemic, the Federal Reserve invested $120 billion directly into the financial system every month through open market purchases. Now, that money is about to be recovered. This has resulted in higher levels of volatility, which are inversely related to liquidity.
In the futures market, margin requirements also affect liquidity. As margin increases, the number of contracts that investors can trade without a margin call decreases. As Bloomberg’s Cameron Crise pointed out last week, the current stock market liquidity is the worst it has ever been outside the financial crisis and the early days of the pandemic.
The U.S. Treasury market, known as the world’s most important market, is also seeing less liquidity. The impact is so great that it is normal to see large, rapid swings in yields for no apparent reason. The Fed said in its report:
Liquidity indicators such as market depth indicate a marked deterioration in liquidity in the US Treasury market.
Liquidity shortages are also caused by the tick size , which refers to the smallest increment in which a stock, futures or bond can be traded. One unit in the stock market is one cent. Also, if the spread between the bid and ask prices is too small, it also reduces the willingness to demonstrate liquidity or post bid and ask prices.
Jared has always supported the return of stock market quotations to decimal and decimal quotations, which will increase the incentive for market makers to issue bid and ask prices. Years ago, the SEC conducted a study of small-cap stocks to determine the effect of different unit sizes on liquidity. Although the results are inconclusive, the agency should include a large number of liquid stocks for informative results.
Most outside observers believe that the wider the spread, the greater the cost to investors. Yes, an individual who buys 100 shares of GE stock in his account may be affected, but an individual is also an investor in funds such as mutual funds that trade on very large scales and will create extra from larger trade increments benefit from liquidity. In stock index futures, the size of the smallest quoting unit is very small, and even if the Nasdaq breaks 10,000 points, the Nasdaq 100 futures are still trading at the lowest point of 0.25.
This is really not good for anyone except high frequency traders. Interestingly, high-frequency traders are the largest and most profitable customers of exchanges, and businesses often want to take care of their largest and most profitable customers. Doing something as simple as increasing the tick size hurts the high-frequency trader, but increases the quality and depth of the market.
Some would prefer to see liquidity drop so that trading becomes more difficult and more expensive, giving investors more incentive to buy assets and hold them for the long term. Jared takes a different view. If an asset is easy to trade, the attractiveness of the asset will increase, thereby increasing its valuation.
Lack of liquidity is a very complex issue, depending on how exchanges are compensated in the form of small fees per share or per contract. More volume equals more fees, which means more profit. He thinks the answer to this problem is simple: increase the incentive to provide liquidity, and the minimum quoting unit can be a small part of that. Liquidity is bad now, but it has the potential to get worse.
Editor/Corrine
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