24 Sep Global financial markets liquidity study
There have been numerous studies and reports to date that offer valuable insights into the topic of market liquidity. These reports, however, often focus on a particular market or a specific regulation and as such, the aggregate impacts of recent regulations on market liquidity are not well understood.
With increasing concerns being voiced on the far-reaching impacts of regulatory developments on market liquidity, including from their bank members, the Global Financial Markets Association (GFMA) and the Institute of International Finance (IIF) commissioned PwC to undertake a broad review of global financial markets liquidity.
This study summarises our findings. It does not necessarily represent the views of GFMA or IIF members, but rather, focuses on a review of financial markets liquidity using available data. We also spoke to financial market participants to interpret and validate the findings from the market data and gather views on future trends.
Importance of liquidity in financial markets
Liquidity is a multi-dimensional concept, generally referring to the ability to execute large transactions with limited price impact, and tends to be associated with low transaction costs and immediacy in execution.
While some market practitioners question whether liquidity can be adequately defined, we consider there are various aspects of liquidity that can be measured and studied. In particular we focus on the four attributes of:
(i) immediacy; (ii) market depth and resilience, (iii) market breadth and (iv) tightness.
We consider liquidity to be important for effective market functioning. Liquidity in financial markets facilitates the efficient allocation of economic resources through the efficient allocation of capital and risk, the effective generation and dissemination of issuer-specific information, and the effectiveness of monetary policy and financial stability. The financial crisis demonstrated the advantages of having a robust financial system which is able to absorb unpredictable shocks, while maintaining market-wide liquidity. We consider market liquidity to be invariably beneficial.
In some markets such as fixed income and bespoke derivative instruments where matching supply and demand for a given instrument becomes more challenging, market makers, such as banks and trading firms are essential in providing liquidity and facilitating transactions by stepping in as counterparties to such transactions. This involves buying or selling financial instruments without an immediate matching transaction and it requires market makers to bear risks relating to the movement in inventory values.
Liquidity conditions can differ significantly across different asset classes, even in normal times. Financial assets with lower levels of liquidity tend to have higher liquidity risk premia, and market participants also tend to face higher transaction costs and wider bid-ask spreads when trading in these instruments. Properly pricing liquidity risk premia is a positive result of post-crisis reforms, which helps to decrease the risks of rapid growth.
