As part of what it terms a continuing effort to foster a productive, data-driven discussion about the nature of liquidity and liquidity provision, FIA PTG has released a white paper entitled Liquidity in Today’s Markets that seeks to promote principles that it says are fundamental to healthy, liquid markets.
FIA PTG says the paper is designed to establish the concepts foundational to a meaningful discussion of liquidity, including what constitutes liquidity and how intermediaries provide liquidity. It also includes recommendations regarding the general parameters necessary to promote liquidity, thereby establishing a basis for further discussion between market participants and regulators.
The paper highlights the different liquidity provision models and hedging techniques that it says all help make a liquid market before moving onto a discussion about the quality of liquidity.
It notes that there are “occasionally” some questions about whether private trading firms (PTFs) actually provide “valuable” liquidity and argues, “This question has a flawed premise because it presumes that liquidity has a quality. We can evaluate the degree of liquidity in a market, but if liquidity is present, we can’t say that it is somehow good or bad. Liquidity is a binary variable—it is either present or it isn’t.”
The white paper also addresses the accusation that “…some liquidity is short lived,” and again observes that liquidity is not a qualitative metric. “Whether or not one party holds the asset after the trade is irrelevant, the paper says. “The liquidity PTFs provide allows for transactions among market participants, regardless of how long they inventory that asset afterwards.”
After reiterating FIA PTG’s opposition to the initial margin rules’ impact on capital requirements for trading firms, the paper observes that, “Regulators have recently stated that initiatives like “all-to-all” trading platforms that focus on reducing the role of the middleman may help re-introduce liquidity in the market.”
FIA PTG says, at a high level, it strongly believes there are also basic market structure principles that contribute to well-functioning liquid markets.
Unsurprisingly for a body that is largely made up of automated traders, the first principle decries the use of artificial latency mechanisms, or speed bumps, arguing these “can be barriers to liquidity provision”.
It also argues that market data should be made publicly available in electronic format in as near real-time as technologically practical; and that any criteria that explicitly or implicitly excludes an entire category of otherwise eligible market participants should be prohibited.
It adds that platform requirements forcing participants to choose between being a liquidity provider or a liquidity “taker” should also be prohibited, and that it must be possible (at least on an opt-in basis) to interact with the market anonymously, on both a pre- and post-trade basis.
“Enhanced transparency is one critical tool in creating liquidity, the paper states. “Improving a market’s ability to reflect all relevant information in real-time increases efficiency in price discovery and bolsters market participants’ willingness to provide liquidity. With clear insight into market operations, liquidity providers are better able to manage risk and provide liquidity.”
The paper also reiterates another longstanding line from FIA PTG, that open and fair access to markets is another key to unlocking liquidity. “Limiting participants, whether directly or through difficulty of access, increases concentration risk and decreases liquidity, especially during periods of market stress,” it states. “For example, during the 2008-2009 financial crisis, liquidity suffered in off-exchange venues, while exchange-traded, transparent, competitive, centrally-cleared markets with broad participation operated continuously and fairly smoothly. Having transparent access to data on diversity among liquidity providers allows market participants to determine if there is concentration risk in any single market.
“Conversely, there are factors that can impede liquidity provision, “ it continues. “Excessive fragmentation, complexity, and limited market access all harm competition and discourage liquidity in markets.
On speed bumps, the paper warns that as the US Securities and Exchange Commission considers latency proposals from multiple exchanges, “We risk creating a hall of mirrors where market participants are forced to route orders to delayed exchanges, only to encounter stale quotes that are no longer accessible. It will be impossible to know which prices are real and which are latent reflections. This could lead to decreased liquidity, lower fill rates and inferior executions.”
The paper cautions against premising any discussion of liquidity with the concepts of good and bad liquidity, which, FIA PTG says, categorises liquidity “simplistically and falsely” based on the type of market participant providing it.
It also argues that comparing the liquidity present in today’s markets with that of markets prior to the financial crisis is unhelpful, as it ignores critical changes in regulation and enhancements in technology. “Instead, we urge an analytical approach that evaluates liquidity within the context of the current health, transparency, efficiency, and competitiveness of our markets and weighs potential policy changes not in terms of their ability to match prior market conditions, but rather to provide liquidity and growth moving forward,” the paper concludes.