Introduction to a Series on Market Liquidity: Part 2

Tobias Adrian, Michael J. Fleming, and Ernst Schaumburg

Market participants and policymakers have raised concerns about the potential adverse effects of financial regulation on 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 or other forces, are therefore of great interest to policymakers and market participants alike.

This week, we will publish a series of blog posts that shed light on the evolving nature of market liquidity. This follows an initial series of blog posts on market liquidity, published in August. We kick off the current series with a post that examines various measures of liquidity in the corporate bond market. The two following posts measure liquidity risk in the corporate bond, Treasury, and equity markets. We then examine the changing role of dealers by presenting estimates of returns to market making, and we consider the part played by dealers in supplying liquidity when mutual funds face redemptions. Finally, we examine the potential for increased uncertainty about the level of liquidity in markets where high-frequency trading is common. Below is a quick summary of the posts in the series:

1. Has U.S. Corporate Bond Market Liquidity Deteriorated?

   by Tobias Adrian, Michael Fleming, Or Shachar, and Erik Vogt. In the corporate bond market, dealer positions, which are considered essential to good liquidity, have declined, even as issuance and outstanding debt have increased. But is there evidence of reduced market liquidity? This post reviews both price- and quantity-based liquidity measures for the market, including trading volume, trade size, bid-ask spreads, and price impact.

1. Has Liquidity Risk in the Corporate Bond Market Increased?

   by Tobias Adrian, Michael Fleming, Or Shachar, Daniel Stackman, and Erik Vogt. Recent commentary suggests concern among market participants about corporate bond market liquidity, even as evidence suggests that liquidity remains ample. One interpretation is that the liquidity risk of corporate bonds might have increased, even as average liquidity has improved. In this post, the authors propose a measure of liquidity risk in the corporate bond market, and analyze its evolution over time.

1. Has Liquidity Risk in the Treasury and Equity Markets Increased?

   by Tobias Adrian, Michael Fleming, Daniel Stackman, and Erik Vogt. Some commentators have argued that liquidity in Treasury and equity markets has deteriorated since the financial crisis, but an inspection of common metrics does not reveal pronounced reductions in liquidity from pre-crisis levels. The authors of this post contend that recent changes in liquidity conditions may best be described in terms of heightened changes in liquidity risk. They suggest a measure that shows that liquidity risk has increased, and discuss some factors behind its rise.

1. Changes in the Returns to Market Making

   , by Tobias Adrian, Michael Fleming, Or Shachar, Daniel Stackman, and Erik Vogt. Since the financial crisis, major U.S. banking institutions have increased their capital ratios in response to tighter capital requirements. Some market analysts have asserted that the higher capital and liquidity requirements are driving up the costs of market making and reducing market liquidity. If it were true that regulations were increasing the cost of market making, one would expect to see a rise in the expected returns to that activity. This post estimates market-making returns in equity and corporate bond markets to assess the effects of regulations.

1. Redemption Risk of Bond Mutual Funds and Dealer Positioning

   , by Tobias Adrian, Michael Fleming, Or Shachar, and Erik Vogt. Market participants have voiced concerns that bond markets seem to become illiquid precisely when they want to sell bonds. Some possible reasons for a decline in corporate bond market liquidity at times of stress include mutual funds’ increasing share of corporate bond ownership and dealers’ reduced share of ownership. In this post, the authors examine the potential effects of outflows from bond mutual funds and the role of dealers in buffering such flows.

1. The Liquidity Mirage

   , by Dobrislav Dobrev and Ernst Schaumburg. This post looks at the trade-off between price efficiency and the resiliency of liquidity introduced by high-frequency trading links between Treasury market trading platforms: On the one hand, low-latency cross-market trading “knits” together the liquidity across distinct liquidity pools and ensures market efficiency through consistent pricing that reflects available information in near real-time. On the other hand, slower traders looking to move large positions may find it hard to “grab” more than a fraction of the liquidity they see on their screens. Patterns in cross-market trading activity suggest that quote modifications by high-frequency market makers rather than aggressive trading are a main cause of the liquidity “mirages” encountered in U.S. Treasury markets. Thus, the changed nature of liquidity is a natural consequence of a new market structure.

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 of research 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.