Markets will become more risky if there is less liquidity. As the rules of the game or market structure changes, there will be unintended consequences on liquidity and the market is moving to an environment that has less liquidity. Market liquidity is the ability of market to trade at fair value in size. It can be measured in the past, but we do not know the true extent of liquidity in the future until it is tested.
There are some key structural features that will affect liquidity. Capital is needed to provide liquidity and make markets. If there is less capital committed to making markets, bid-ask spreads will increase. There will not be strong buyers when sellers come to market. Larger traders on one side of the market have to be matched by market participants on the other side. Market makers provide trading immediacy at fair prices. If bank capital committed to market making is reduced and there are no alternative forms of capital, liquidity will suffer.
Diversity of opinion also is critical. Liquidity will not be provided if everyone is on one side of the market. The easiest way to get differences of opinion is through having more firms provide liquidity and trade the market. More firms trading lead to more opinions.
Market uncertainty reduces liquidity and the move to electronic markets may foster more uncertainty. Traders cannot call around and gauge opinions of other market participants. If the rules of the game change, liquidity will become scarcer. Bid-ask spreads will increase if there is market uncertainty on why trading occurs. You will not trade with those who you believe have an information advantage.
Government regulators and central banks have been trying to make markets more resilient by changing the rules of the game. Policy has reduced leverage, changed financing options, reduced bank activity in non-lending business, reduced profitability from trading activity, cut proprietary trading, changed money market redemption terms and pricing, and reduced shadow banking activities. All of these changes have addressed key macro prudential issues in financial markets, but they also may made liquidity a scarcer resource.
The BOE's Mark Carney is sounding a alarm in his "future of financial reform" speech. Liquidity is critical for functioning markets, but may have been given a priority in the post financial crisis environment.
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