Market Liquidity: A Primer 
                   
                  June 2015  l  The Brookings Institution 
                  Douglas J. Elliott, Fellow, Economic Studies 
                   
                  Introduction                                                 Overview and recommendations  
                                                                                
                  US financial markets are critical to the                     Market liquidity refers to the ability of buyers 
                  functioning of our entire economy, providing                 and sellers of securities to transact efficiently 
                  more credit, for example, than banks do. Our                 and is measured by the speed with which large 
                  unusually large financial markets have been an               purchases and sales can be executed and the 
                  American competitive advantage for years,                    transaction costs incurred in doing so. These  
                  providing a cost-effective means of matching                  
                  investors with worthy companies and projects.                costs include both the explicit commission or 
                  Therefore, the current debate about whether                  bid/ask spread and the, often larger, loss from 
                  market liquidity is drying up is an important                moving the market price by the act of making 
                  one, since the ability to buy and sell securities is         the bid or offer for a large block. This latter 
                  central to market functioning. This primer                   effect ties market liquidity to price volatility, as 
                  provides an introduction to the issues by                    transaction volumes lead to bigger price 
                  addressing the following questions.                          movements when markets are illiquid. 
                                                                                
                      •    What is market liquidity?                           We care about market liquidity because it 
                      •    Why do we care about it?                            affects the returns for investors, such as those 
                      •    Has it actually declined?                           saving for retirement or college, and the costs 
                      •    What do the recent bouts of market                  to   corporations, governments, and other 
                           volatility mean?                                    borrowers. Further, illiquid markets are more 
                      •    Why would we expect market liquidity                volatile. At the extreme, volatility can help 
                           to be down?                                         trigger or exacerbate financial crises. Even the 
                      •    Will market liquidity decline further?              average level of volatility matters, as it is 
                      •    What factors might offset tightening                factored into the interest rates  demanded by 
                           liquidity?                                          investors and paid by borrowers. 
                      •    What should be changed to improve                    
                           market liquidity?                                   Market liquidity is a complicated issue in part 
                                                                               because it is not clear what is happening to 
                  Before going systematically through these                    underlying liquidity. Pretty much everyone 
                  questions, the following section provides an                 agrees that markets are less liquid than they 
                  overview and recommendations.                                were in the run-up to the financial crisis, but it 
                                                                               is not clear that this is a problem, since those 
                                                                               liquidity levels were unsustainable and 
                                                                               evaporated quickly under stress. The harder 
                                                                               parts are to compare liquidity to an optimal 
                                                                               sustainable level and to project liquidity into 
                                                                               the future. There is no agreement on either the 
                                                                               optimum level or the future course of market 
                                                                               liquidity. 
                                                                                
                                                                            
                 Market Liquidity: A Primer 
                 Brookings 2015 
                 Despite the uncertainties, policymakers are                at least four incidents in the last couple of years 
                 right to take this issue seriously and to worry            in which markets showed extreme volatility that 
                 about the risks. There appears to have been a              may have been exaggerated by lower liquidity, 
                 decline in underlying liquidity in the markets             such as the “taper tantrum” in the bond 
                 and this seems highly likely to worsen to some             markets. It is difficult to know if these are 
                 extent. There are numerous factors at work,                isolated incidents or the tip of a dangerous 
                 including the evolution of the structure of                iceberg. On the other hand, there are a number 
                 financial markets and the effects of unusual               of indicators, such as average bid/ask spread, 
                 economic conditions, especially extremely loose            that do not show signs of a less liquid market, 
                 monetary policies and massive direct central               so while there appears to have been an overall 
                 bank purchases of bonds. I also believe we have            decrease in liquidity, the evidence is 
                 overshot in our regulations in a way that will             ambiguous. 
                 cramp market liquidity excessively, producing               
                 more social costs than the benefits of greater             Thus, the effects we have seen already are not 
                 financial stability. To be clear, most of what has         deeply worrisome on their own. The bigger 
                 been done is positive; it is a matter of                   issue is the probability that market liquidity will 
                 recalibrating the details to reduce the social             considerably worsen going forward. First, the 
                 costs while keeping the core benefits.                     very loose monetary policies of central banks 
                 Unfortunately, this cost-benefit analysis is               around the world appear to have provided 
                 complex and still subjective at this point, in part        considerable support for market liquidity while 
                 because so much of what is happening to                    also holding down price volatility. When 
                 liquidity remains ambiguous and the largest                monetary policies eventually tighten, market 
                 effects are likely to be in the future.                    liquidity is likely to be more of a problem. 
                                                                            Second, banks and large dealers are almost 
                 Whatever the overall conclusions about                     certain to cut back further on their liquidity 
                 regulation, it is clear that the cumulative effects        provision and to raise their prices over the next 
                 of a series of regulations have made it more               couple of years. Many of the rules that increase 
                 difficult and expensive for banks and large                their costs are only now being finalized or are 
                 securities dealers to act as market makers.                being phased in over time. Further, dealers 
                 (These rules include the liquidity coverage ratio,         know they will lose customers if they make one 
                 the net stable funding ratio, the supplementary            big move, rather than spreading the pain over 
                 leverage ratio, various changes to the capital             multiple years, especially if their competitors 
                 rules under the Basel  capital accords, the                take smaller steps.  
                 Volcker Rule, and others.) Smaller dealers,                 
                 hedge funds, and similar firms will pick up some           In sum, there are good reasons to worry about 
                 of the slack as the large dealers pull back, but           market liquidity and to believe that 
                 there are real limitations on their ability to do          policymakers may have unintentionally 
                 so cost-effectively. The markets can also adapt,           overshot. However, the disaster scenarios that 
                 such as by moving to agency rather than                    some suggest do not seem plausible, nor does 
                 principal models and by embracing electronic               any regulatory overshoot mean that we have to 
                 markets, but, again, there are some serious                redo financial reform in major ways. This is a 
                 limits on how far these moves can go.                      matter of taking the issue seriously and 
                                                                            recalibrating a series of technical measures to 
                 The net result should logically be decreased               reduce the damage to market liquidity without 
                 liquidity and we have already seen much lower              increasing the risks to financial stability in any 
                 securities inventories held for market-making              significant way. At this point, the key is to revisit 
                 purposes by dealers along with some other                  the various key regulations and to seriously 
                 signs of lessened liquidity. There have also been 
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               Market Liquidity: A Primer 
               Brookings 2015 
               review the costs and benefits of the choices        One of the major effects of this market 
               that were made about the details.                   structure is that the great majority of bonds are 
                                                                   bought and sold through dealers rather than 
               What is market liquidity?                           traded on exchanges, since there is not enough 
                                                                   transaction volume to support exchange trading 
               In financial terms, the “liquidity” of any asset    of each of the individual bonds. These dealers 
               refers to the combination of the degree of ease     do not normally charge a commission, but are 
               with which it can be sold (or bought) in a timely   paid through their expected profits from 
               manner and the level of costs associated with       bidding for bonds at one price and offering to 
               that sale, either in terms of transactions costs    sell them at a higher one. The “bid/ask” spread 
               or the acceptance of a lower price in order to      between the two quotes can be viewed as 
               find a buyer in a reasonable time.  Houses are      consisting of two parts. A portion is the 
               relatively illiquid assets, since they can take     equivalent of a commission and is necessary to 
               months to sell, there are quite substantial         cover expenses and provide a reasonable profit 
               transaction costs, and, depending on market         for helping customers to execute transactions. 
               conditions, the seller may have to take a hit to    The second part compensates dealers for the 
               move the house in a reasonable time period. On      risk that they will lose money on a transaction 
               the other hand, a US Treasury bond is highly        by buying too high or selling too low, as well as 
               liquid. It can easily be sold within hours,         covering the costs of holding a securities 
               transaction costs are minimal, and there are        inventory to facilitate transactions, including 
               many potential buyers who are willing to pay        the necessary levels of capital and liquidity to 
               roughly the bond’s theoretical market value.        back their inventories. Therefore, one of the 
                                                                   significant measures of market liquidity is the 
               Recent concerns about “market liquidity” refer      average bid/ask spread, since it represents an 
               to the functioning of markets for purely            important transaction cost. 
               financial assets, particularly bonds issued by       
               both governments and corporations, also             Why do we care about it? 
               known as “fixed income” instruments since they       
               promise a fixed set of payments to the owner.       Most of the credit provided to businesses and 
               Sometimes these discussions have broadened          households in this country is ultimately supplied 
               out to reference derivatives based on these         through financial markets. (This is a contrast 
               bonds or the related markets in foreign             with the rest of the world, where credit 
               currencies and commodities.                         primarily ends up on bank balance sheets). The 
                                                                   suppliers of credit are insurers, pension funds, 
               It is important to understand that the fixed        mutual funds, individual investors, and others. 
               income market is quite different from the stock     The ultimate sources of all these funds are 
               markets with  which most people are more            households who rely on their returns from 
               familiar. There is usually one type of common       these securities to provide funding for 
               stock for each public company (occasionally         retirement, educational expenses, and other 
               two);  whereas firms and governments issue          needs. So the functioning of these markets has 
               many distinct bonds each. They differ in            significant impacts on the economy as a whole. 
               maturity, interest rate, and other material         When liquidity declines, there are a series of 
               features, so that they are not inter-changeable,    effects: 
               even though they are affected by some 
               common factors, particularly those related to 
               the creditworthiness of the issuer. 
                
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                 Market Liquidity: A Primer 
                 Brookings 2015 
                 Direct transaction costs for investors rise.  In         conditions. At other times, volatility is affected 
                 some cases, external factors, such as increases          by changes in bid/ask spreads or other 
                 in regulatory requirements for trading, directly         elements of liquidity. When it is more expensive 
                 push bid/ask spreads higher, which raises                or harder to trade, then fewer traders are 
                 transactions costs for investors, which is one           willing or able to step in when prices move out 
                 aspect of liquidity. Further indirect effects result     of line by modest amounts, allowing prices to 
                 from cutting transaction volumes, which may              swing more widely.  
                 also lengthen the time necessary to complete a            
                 transaction.                                             Whatever the cause of increased volatility, it 
                                                                          generally reduces the return for investors who 
                 In other cases, the causality runs in the other          are buying or selling in any significant size, as 
                 direction, and markets initially become less             their initial purchases or sales will move the 
                 liquid in some other way, such as through a rise         market price further in the wrong direction for 
                 in the volatility of price movements. Bid/ask            them. 
                 spreads would then usually increase as well, for          
                 several reasons. Transaction volumes would               There is greater potential for financial crises. 
                 tend to fall, so the dealer’s fixed costs would be       Illiquidity in financial markets can help trigger or 
                 spread over fewer transactions, raising the cost         exacerbate a financial crisis by creating actual 
                 per transaction. Further, risk premiums would            or paper losses at banks or other financial 
                 rise as well to cover the higher price volatility,       institutions. If a bank needs to raise cash 
                 as may also be true of the capital and liquidity         quickly, perhaps to meet deposit outflows in 
                 charges, at least if illiquidity persists.               the event of a loss of confidence in that 
                                                                          institution, they will likely need to sell 
                 Whatever the derivation of the higher                    securities, especially if they have an excessive 
                 transaction costs, they flow through to lower            mismatch between the maturities  of their 
                 returns for investors when they buy or sell the          assets and liabilities. In illiquid markets, this 
                 instrument.                                              would require “fire sales” in which the seller 
                                                                          accepts a significantly lower price in order to 
                 Volatility of prices increases.  The biggest             get cash quickly. In addition to the direct loss to 
                 factors moving securities prices are those that          the troubled institution, which may threaten its 
                 affect perceptions of their fundamental value,           solvency, rapid declines in securities prices can 
                 such as good or bad news about a firm’s                  affect other institutions, either because they 
                 creditworthiness or an overall move in interest          too need to sell or because they use “mark to 
                 rates. However, the rapidity and extent of price         market” accounting for their assets and 
                 movements is also influenced by market                   therefore paper losses directly affect their 
                 liquidity. If there are many potential buyers and        capital positions. 
                 sellers and they can transact quickly, easily, and        
                 cheaply, then price movements tend to be                 Bond prices fall as Investors demand higher 
                 smoother as news events are factored into                liquidity risk premiums. When investors decide 
                 prices quickly based on the market consensus             the minimum interest rate they will accept on a 
                 about their significance. Similarly, if a market         bond, they take account of multiple factors. 
                 participant wants to buy or sell a large block of        First, they need a base return that compensates 
                 bonds, they can do so without greatly moving             them for giving up the use of their funds until 
                 the price.                                               the maturity of the bond, often known as the 
                                                                          “time value of money.” Second, they need to be 
                 As with transaction costs, sometimes volatility          compensated for credit risk, the possibility that 
                 directly changes, perhaps due to higher                  they will not be repaid in full. Third, they may 
                 uncertainty about economic or monetary policy            charge an interest rate risk premium to reflect 
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