Order processing costs are frictions that impede the process of trading though they essentially ensure its completion. As J. Board (2002) affirms, “the relative costs of trading on an exchange are likely to determine where the bulk of trading volume ultimately resides. ” Equally, Madhavan’s theoretical comparison of trading of a cross-listed security (2000), indicated that if order costs were a function of volume, in the long-run, trading would be consolidated in the exchange with the lowest per unit trading costs.Inventory costs for dealers represent price risk and the costs of financing the inventory.
Longer holding periods, induced by trade imbalances, increase costs such as that of the opportunity of money tied up in the inventory. However, brisker trading brings down holding period times, improving liquidity and the perception of settlement risk. (Board et al, 2002) One of the main reasons cited for the poor performance and relative illiquidity of the CAC 40 is the draconian fiscal policy enforced by the French government.The indirect effect on liquidity should not be overlooked, and the recent decision to no longer tax dividends in the U.
S. is a major development. Market Structure and Trading Platform The studies conducted in the recent past by people such as Huang and Stoll (1996) have led many others to question many existing trading practices. Most criticism has been centred on dealer markets, where internalisation and preferencing can apparently lead to poorer execution and collusion, increasing spread sizes.Wang (1999) was another to examine bid-ask spreads for futures on the SFE10 on the day-trading open outcry and evening screen based systems. His evidence hinted that higher volatility had twice the effect on spreads on the open-outcry system. Transparency11 is another contentious area. When there is more information available on quotes, a significant contribution should be made to the provision of liquidity to the market.
(Franke ; Hess, 1996)An interesting 1994 publication from the British office of fair trading questioned why market makers “were so vehement in their demands for a delay” in publicising large trades when the research showed that while large trades did affect prices permanently, the delay in their announcement did not. They concluded that market makers were using the delay to improve their positions. 12 Another study by Franke ; Hess (1996), which analysed the values of German long-term bond contracts cross-listed on separate exchanges, illustrated that liquidity was reduced in periods of higher volatility on the DTB13, as opposed to the LIFFE14.Concluding Remarks So, in essence, liquidity is influenced by numerous factors, stretching from trading frictions to fiscal and monetary policy, even social dynamics. Sentiment is, as ever, the greatest underlying pressure exerted on prices. Narrower, thinner markets are illiquid.
Fewer offers mean wider spreads, higher volatility and fluctuating prices. The broader the market, the greater the propensity for that market to be liquid. People react in different ways to new information.In major crises, the perception of information influences how the market copes. If markets are broader, prices will not be as severely affected as they might be, with differing reactions from bulls and bears. Greater transparency, better access to information and lower trading costs can improve the efficiency of markets. Liquidity is essentially a measure of how well the market functions.
By improving liquidity through the eradication of friction, we should be able to strengthen the confidence that holds the fibres of finance together.