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December 19, 2011

When Do Trading Frictions Increase Liquidity?

Gara Afonso

Economists tend to assume that frictions that limit trading in financial markets reduce liquidity and lower investor welfare. In this blog I discuss a recent staff study of mine that challenges that conventional wisdom. I explain how introducing trading frictions—such as circuit breakers—that slow or halt trading in an over-the-counter market experiencing a fire sale might, paradoxically, lead to higher liquidity and investor welfare.

    Trades in over-the-counter (OTC) markets are negotiated directly between a buyer and seller, in contrast to trades in an exchange, where an electronic facility automatically matches the bids and offers of many buyers and sellers. Examples of OTC markets include those for mortgage-backed securities, derivatives, corporate bonds, bank loans, and small-capitalization equity. Over the past twenty-five years, OTC markets have experienced rapid development and have grown enormously in terms of size and importance. For example, the notional amounts outstanding of only OTC derivatives exceeded $600 trillion at the end of 2009, according to the September 2010 BIS Quarterly Review.

    Finding counterparties and privately negotiating the terms of a transaction are essential elements of trading in OTC markets. In economics and finance theory, these defining features of OTC markets are explained in the search literature. From the seminal work of Peter Diamond, Dale Mortensen, and Christopher Pissarides (this year’s three Nobel Prize Laureates in Economic Sciences), search methods have been broadly used in different areas of economics. Darrell Duffie, Nicolae Gârleanu and Lasse Heje Pedersen were the first to study trading frictions in OTC markets; their research was followed by the work of several academics including Ricardo Lagos, Guillaume Rocheteau, Dimitri Vayanos, Tan Wang, and Pierre-Olivier Weill, and others. Search techniques have also been applied to the study of specific OTC markets such as the government-bond market and the federal funds market.

Why reducing frictions might not be the best policy

Consider an OTC market where, before a transaction can take place, an investor needs to find a potential counterparty and then bargain over the terms of the transaction, e.g., the price of the asset. Suppose also that investors have access to different investment opportunities and can choose among them, according to the returns on the different investments. Typically, in financial markets, there is a well-known positive externality such that as more investors are attracted to a particular market, trading costs fall, which in turn attracts more investors and further lowers the cost of trading. A key contribution of my recent NY Fed Staff Study (forthcoming in the Journal of Financial Intermediation) is to consider a second (negative) externality that arises when investors are attracted to a specific side of the market, for example, the sell-side, as in the case of a fire sale.

    To see how this second externality works, suppose that a significant number of investors who were holding this asset decide to sell it. If the increase in the number of sellers is matched by a rise in the number of buyers, trading costs in the OTC market would fall. However, if the increase of investors concentrates solely on one side of the market (the sell side in this case), there will be many sellers per buyer, and hence it will be more difficult for a seller to meet a buyer and negotiate the terms of the transaction. In other words, as the market becomes congested, transaction costs will increase. However, since investors can choose between different investment opportunities, if trading in this market becomes more costly, they may prefer other investments. As fewer buyers are attracted to this market, the proportion of buyers to sellers becomes even more unbalanced and trading becomes even more costly.

    In one-sided markets that tend to play key roles in financial distress, reducing frictions to facilitate trading may, paradoxically, diminish market liquidity and make investors worse-off. Why? In a market where many participants want to sell and few are interested in buying, reducing frictions and facilitating trade make it easier for a buyer to meet a seller and to purchase the asset (this may lead to an increase in trading volume). However, at the same time, as a buyer acquires the asset (and the pool of potential buyers shrinks), the ratio of remaining buyers to sellers in this market becomes more unbalanced. This leads to higher trading costs, lower prices, and, ultimately, lower liquidity (measured by the price discount). As transaction costs rise and liquidity evaporates, the market becomes less attractive to potential new investors. Also, as transacting becomes more costly and illiquidity rises, investors who hold the asset in their portfolios as well as those who are trying to sell and exit the market become worse off. In this scenario, reduced frictions can decrease total welfare.

    Examples of measures that could raise liquidity and welfare are trading halts or circuit breakers or other mechanisms to slow down trading in volatile securities. A trading halt would simply stop trading when there is a significant imbalance in the pending buy or sell orders in a security. Similarly, circuit breakers would halt trading when a market declines beyond specific targets levels. Rules in the spirit of those proposed by the Securities and Exchange Commission (SEC) on May 18, 2010, in response to the market disruptions of May 6 would also enhance liquidity in one-sided markets experiencing fire sales.

The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

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