Market Liquidity: A Hide and Seek Game between Unobservable Buyers and Sellers

Blog Post by Best Fin Investment



The action of buying & selling, referring to market liquidity

Table of Contents:


Introduction:
Liquidity refers to the ease with which an asset can be bought or sold in the market without affecting its price significantly (essentially measuring how quickly and at what cost an asset can be converted into cash). Highly liquid assets, such as major stocks and government bonds, can be traded rapidly with minimal impact on their price, while illiquid assets, like real estate or small-cap stocks, may require more time and may incur a greater cost to sell. Liquidity is a critical aspect of financial markets. In this blog post, we delve into the multifaceted nature of market liquidity, exploring its implications for price formation, volatility, and overall market stability.

Vanishing Revealed Liquidity:
Liquidity at any given moment is akin to an iceberg: only a small portion of the vast underlying supply and demand is visible, while the majority remains hidden beneath the surface. Liquidity providers face the risk of trading with informed participants, so they limit the amount of liquidity they offer to mitigate this risk. Consequently, markets function with minimal visible liquidity but significant hidden liquidity. Even the most liquid markets aren't as liquid as they appear, making them more like strategic games of hide and seek between unseen buyers and sellers who must navigate a narrow channel of available liquidity. Although buyers and sellers are eager to trade, they are reluctant to fully disclose their intentions.
This scarcity of accessible liquidity has a crucial implication: large trades must be broken down into smaller parts. Even an insider with reliable information about an asset's future price cannot act on all that information at once without risking market disruption and revealing their advantage. Instead, traders need to break up large orders and carefully plan their trading strategy to achieve the best possible execution price [1,3].

Implications for Price Formation:
Empirical studies indicate that markets function under a regime characterized by minimal visible liquidity and substantial hidden liquidity, leading to fluctuations in liquidity that may account for the market's extreme sensitivity to price changes [1,4]. Indeed, since the outstanding liquidity of markets is always very small, trading is inherently an incremental process, and prices cannot be instantaneously in equilibrium and cannot instantaneously reflect all available information [3]. Hence, there is nearly always a substantial gap between latent market offer and latent market demand, which only gradually gets incorporated into prices [3].
Note that it was also observed that liquidity fluctuations affect the tail exponent characterizing the distribution of large price returns [6].

Interplay between Market Liquidity and Volatility:
Liquidity generally plays the most significant role in driving volatility, particularly over short time periods. Therefore, grasping the concept of liquidity is the essential first step in comprehending volatility [6]. Specifically, periods of high volatility correspond to low liquidity and vice versa [6].

Implications for Market Stability:
A common thread across different financial crises is the sudden disappearance of market liquidity. Whether it’s banking panics, stock market crashes, the subprime mortgage collapse, or the Quant meltdown of August 2007, all these events illustrate the critical role of liquidity breakdowns [5].
Even micro-crises and price jumps in the absence of news may be explained by liquidity fluctuations [1]. It has indeed been observed that a dangerous feedback loop exists between the bid-ask spread and volatility which may lead to micro-liquidity crises and price jumps [1].
Finally, the presence of uninformed (i.e., noise) traders is crucial for the proper functioning of financial markets. When market-makers suspect that other participants possess too much information, they may be unable to set a bid-ask spread that allows them to break even or make a profit, potentially leading to a liquidity crisis. In other words liquidity providing is only viable if the fraction of informed trades is sufficiently small [2]. By informed trades we refer to transactions made by investors who have access to valuable information that is not yet fully reflected in the current market prices. These traders use their knowledge (often based on proprietary data analytics, proprietary models, and/or non-widespread information) to anticipate future price movements and make decisions that give them an advantage over uninformed traders.

Intraday Liquidity Dynamics:
It was observed that liquidity is much more scarce at the day open than it is at day close (even more so for large-tick stocks), which may reach a ratio of 20 between just before close compared to just after open [2].
Further the bid-ask spread tends to narrow throughout the trading day, particularly for small-tick stocks. This may be interpreted as a reduction of the adverse selection faced by liquidity providers (i.e. market-makers), as the overnight news gets progressively digested by market participants [2].
Note that small-tick stocks are stocks where the minimum price movement, or "tick size," represents a relatively small percentage of the stock's overall price. In these stocks, the spread between the bid and ask prices is usually narrow, and they tend to have higher liquidity. This means that trades can happen more frequently with smaller price changes, and market-makers may earn smaller profits on each trade but benefit from the higher trading volume. Large-tick stocks, on the other hand, have a tick size that represents a larger percentage of the stock's price. The bid-ask spread for these stocks is typically wider, meaning the price must move more significantly before trades occur. These stocks often have lower liquidity compared to small-tick stocks, and market-makers may see larger profits per trade, but trades occur less frequently. The larger spread can also create more significant price fluctuations for each trade.

Conclusion:
Market liquidity is a multifaceted phenomenon that influences various aspects of financial markets, including price formation, volatility, and overall market stability. By recognizing the importance of liquidity fluctuations and their implications for market dynamics, analysts and investors can gain valuable insights into market behavior and make more informed decisions.


References:

[1] Bouchaud J.P., "The endogenous dynamics of markets: price impact, feedback loops and instabilities", Lessons from the credit crisis, pp.345-74, 2011.
[2] Bouchaud J.P., Bonart J., Donier J., Gould M., "Trades, Quotes and Prices: Financial Markets Under the Microscope", Cambridge University Press, 2018.
[3] Bouchaud J.P., Doyne Farmer J., Lillo F., "How markets slowly digest changes in supply and demand", In Handbook of Financial Markets: Dynamics and Evolution, Chapter 2, 2009.
[4] Doyne Farmer J., Gerig A., Lillo F., Mike S., "Market efficiency and the long-memory of supply and demand: Is price impact variable and permanent or fixed and temporary?", Quantitative Finance, vol. 6, issue 2, pp. 107-112, 2006.
[5] Lo A.W., "Adaptive Markets: Financial Evolution at the Speed of Thought", Princeton University Press, 2019.
[6] Mike S., Doyne Farmer J., "An empirical behavioral model of liquidity and volatility", Journal of Economic Dynamics and Control, vol. 32, issue 1, pp. 200–234, 2008.



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