Introduction to a Series on Market Liquidity

Tobias Adrian, Michael J. Fleming, and Ernst Schaumburg

Market participants and policymakers have recently raised concerns about market liquidity—the ability to buy and sell securities quickly, at any time, at minimal cost. Market liquidity supports the efficient allocation of capital through financial markets, which is a catalyst for sustainable economic growth. Changes in market liquidity, whether due to regulation, changes in market structure, or otherwise, are therefore of great interest to policymakers and market participants alike.

This week, we will publish a series of five posts that shed light on the evolving nature of market liquidity. We kick off the series with a post that examines various measures of liquidity in the Treasury market. We then present three posts that consider the evolving role of high-frequency trading in financial markets, particularly the Treasury market. The last post documents the stagnation of dealer balance sheets since 2009 and explores possible drivers of this behavior. Following is a quick summary of the posts in the series:

1. Has U.S. Treasury Market Liquidity Deteriorated? by Tobias Adrian, Michael J. Fleming, Daniel Stackman, and Erik Vogt. The issue of financial market liquidity has received tremendous attention of late. This emanates not only from market participants’ concerns that regulatory and structural changes have harmed dealers’ market-making abilities, but also from events such as the taper tantrum and the flash rally, in which sharp price changes were observed amid seemingly little news. But is there really evidence of a sustained reduction in liquidity? In this post, the authors address this question with respect to the U.S. Treasury market.

1. Liquidity during Flash Events, by Ernst Schaumburg and Ron Yang. “Flash events”—extremely large price moves and reversals played out over just a few minutes—have occurred in some of the world’s most liquid markets in recent years. What makes these events remarkable is that they seem to have been unrelated to any discernable economic news during the event window, beyond the market movements themselves. In this post, the authors consider important similarities and differences between three major flash events that occurred between May 2010 and March 2015 in U.S. equities, euro-dollar foreign exchange, and the U.S. Treasury markets.

1. High-Frequency Cross-Market Trading in U.S. Treasury Markets, by Dobrislav Dobrev and Ernst Schaumburg. The authors examine the increased correlation of high-frequency trading activity across assets and trading platforms, as illustrated by futures trading on the CME and benchmark bonds traded on interdealer platforms. The findings highlight the importance of both the changing nature of participation and the discrete technological changes that have enabled near instantaneous coordinated trading. Such trading maintains a stable pricing relationship between related assets, even during periods of extraordinarily high volatility.

1. The Evolution of Workups in the U.S. Treasury Securities Market, by Michael J. Fleming, Ernst Schaumburg, and Ron Yang. The market for benchmark U.S. Treasury securities is one of the deepest and most liquid in the world. Although trading in the interdealer market for these securities is over-the-counter, it features a central limit order book. A distinctive feature of this market is the “workup” protocol, whereby the execution of a marketable order opens a short time window during which market participants can transact additional volume at the same price. The authors document the continued important role played by the workup, show some ways in which trading behavior in the workup has evolved, and explain some of the observed changes.

1. What’s Driving Dealer Balance Sheet Stagnation? by Tobias Adrian, Michael J. Fleming, Daniel Stackman, and Erik Vogt. Securities brokers and dealers engage in the business of trading securities on behalf of their customers and for their own account, and use their balance sheets for trading operations, particularly market making. Total financial assets of dealers in the United States have shown no growth since 2009. This stagnation in their balance sheets raises the worry that dealers’ market-making capacity could be constrained, adversely affecting market liquidity. The authors investigate the stagnation of dealer balance sheets, focusing particularly on the boom and bust of the housing market and the ensuing financial crisis.

Disclaimer

The views expressed in this post are those of the authors 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 authors.

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Tobias Adrian is the associate director and a senior vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Michael J. Fleming is a vice president in the Bank’s Research and Statistics Group.

Ernst Schaumburg is an assistant vice president in the Federal Reserve Bank of New York’s Integrated Policy Analysis Group.