Financial markets operate through the medium of liquidity, enabling the efficient transfer of assets between buyers and sellers. The normal state of liquidity is asymmetric, ebbing and flowing continuously around an asset’s fair value until a supply and demand equilibrium appears.
Price is the conduit for this equilibrium, and the process is known as price formation; it is fuelled by competition, and benefits from market concentration and price transparency. High demand dictates a higher price, low demand a lower price. Thus liquidity and volatility are inextricably linked and in turn so are trading costs, risk and asset returns.
This is relevant to investors and issuers alike. A company may have great financial results, but if the shares are illiquid, investors require a higher risk premium and therefore a lower price.
Like fund managers, issuers care about liquidity too and work hard to maintain it in the market through corporate actions and other interventions. They also care about inclusion in indexes as they form the basis of investment vehicles (or products) that allow for passive investment of which many ETFs are created from. These investment vehicles increase liquidity and demand for their stocks, as we see during re-constitution events. Investors expect management to be aware of the liquidity in their shares.
Our Liquidity Matters series helps both generalists and specialists across all industry stakeholders to understand the market structure and its application to practical matters such as asset selection and trading, and highlights recent trends and notable events. Complexity in the market micro-structure, often referred to as the fragmentation of liquidity pools, presents challenges for managing trading costs and therefore asset returns, for accurate risk management and reporting. Our aim is to help clarify and summarise this complexity, using illustrations from our sophisticated data analytics and recent market observations.
