Optimal order display in limit order markets with liquidity competition

Order display is associated with benefits and costs. Benefits arise from increased execution-priority, while costs are due to adverse market impact. We analyze a structural model of optimal order placement that captures trade-off between the costs and benefits of order display. For a benchmark model of pure liquidity competition, we give a closed-form solution for optimal display sizes. We show that competition in liquidity supply incentivizes the use of hidden orders to prevent losses due to over-bidding. Thus, because aggressive liquidity competition is more prevalent in liquid stocks, our model predicts that the proportion of hidden liquidity is higher in liquid markets. Our theoretical considerations ares supported by an empirical analysis using high-frequency order-message data from NASDAQ. We find that there are no benefits in hiding orders in il-liquid stocks, whereas the performance gains can be significant in liquid stocks.     

Compensation for illiquidity in China: Evidence from an alternative measure

This paper shows that liquidity is an important source of priced risk in China. Using A-share stocks in Shanghai and Shenzhen Exchange over the period 2007–2017, we examine the influence of liquidity on stock returns. A new liquidity measure that captures multiple dimensions of liquidity is proposed. Fama-Macbeth cross-sectional regression shows that the expected return is negatively correlated with liquidity. Based on Fama and French (1993), we propose a five-factor pricing model by incorporating reversal factor and liquidity factor. Time-series regressions show that the liquidity factor makes significantly marginal contributions to explaining excess stock returns. The liquidity factor based on the proposed measure works better than alternative liquidity measures such as turnover, Amihud illiquidity measure and the measure in Liu (2006).     

权证发行对标的股票流动性的影响分析--基于中国股市的实证研究

本文通过实证方法研究了权证发行对标的股票流动性的影响。通过比较权证发行前后不同流动性指标变化情况发现：权证发行普遍增强了标的股票的流动性，认沽组标的股票的流动性改善最多，认购组次之，认购认沽组最差。对结果的分析发现，标的股票流动性的改善与权证发行后股价变化趋势密切相关，而认购组没有认浩组标的股票流动性改善多，有可能是由我国自身的市场机制引起的。     

Risk contagion in the banking network: New evidence from China

Based on data from 111 Chinese banks over the 2013–2016 period, this paper estimates the interbank bilateral lending matrix using the maximum entropy method. The estimated matrix is used to simulate the effects of credit and liquidity shocks on China’s banking network. Simulation results show that, under the extreme pressure scenario, the contagion arising from a liquidity shock is significantly stronger than the effect of a credit shock, indicating the importance of liquidity in the banking system. The contagion effect arising from a credit shock does not vary much over the sample period. However, the contagion effect arising from a liquidity shock decreases significantly, which could be attributed to contraction in interbank business due to stricter interbank business supervision. The simulation results also identify the most important and most vulnerable nodes of the banking system. An increase in the level of capital level can enhance the ability of banks to withstand credit and liquidity shocks. Our analysis also suggests that risk contagion faced by China’s banks varies across banking network structures.     

Insuring Banks Against Liquidity Shocks: The Role of Deposit Insurance and Lending of Last Resort

Abstract.  It has long been recognized that banks' simultaneous provision of monitoring and liquidity services is advantageous but leaves them susceptible to liquidity shocks that may culminate in a system failure. Because a system failure is costly, this provides a rationale for adopting arrangements, including a lender of last resort and deposit insurance (DI), to insure banks against liquidity shocks. These arrangements have proven themselves very successful, but they have also been the source of problems. Researchers have identified some of the main sources of these problems and have suggested ways to improve the design of these arrangements, but there are still many issues that remain unaddressed. This paper reviews the literature on the two arrangements that most countries have adopted to insure banks against liquidity shocks, a lender of last resort and DI, and compares the design of these arrangements across countries. The paper ends with a brief summary of the key lessons learned about the design of these arrangements and the issues related to them that remain unaddressed.     

Investor heterogeneity and commonality in stock return and liquidity

This paper examines how the trading activities of different investor types are related to common return and liquidity movements. Using a unique dataset, we decompose the daily return and liquidity of individual stocks into price impact components attributable to trades of institutional investors and retail investors. We then investigate the variation of each component relative to market-wide return and liquidity. We show that institutional trades contribute more than retail trades to liquidity commonality. However, retail trades contribute more strongly to return co-movement. The incremental contribution of retail trades to the co-variability of stock returns is more pronounced for firms with high information asymmetry.     

Determinants of commonality in liquidity: Evidence from an order-driven emerging market

Using an extensive, time-series, cross-sectional data-set of actively traded Indian stocks with up to 1.75 million firm-day observations, we discern the key determinants of commonality in liquidity among emerging markets. The paper shows evidence for both supply-side and demand-side factors contributing to liquidity commonality. However, the results are more supportive towards supply-side rationale for liquidity commonality among the firms where regulators and banks play an important source of commonality in liquidity, especially during market turmoil. Results are partially driven by the fact that the Indian stick exchange is an order-driven market. Economic activities like cheap exports and undervalued currency, rather than correlated trading by the institutional investors determine the demand for liquidity. These findings endorse the effect of high firm value, market return, liquidity, volatility, turnover, and alternate proxies of commonality in liquidity estimation.     

Commonality in liquidity among Middle East and North Africa emerging stock markets: Does it really matter?

This study investigates commonality in daily liquidity among 11 emerging stock markets from the Middle East and North Africa from January 2005 to June 2017. First, we test long memory in liquidity in these markets. Second, we select a number of factors eligible to affect liquidity commonality among local, regional and global factors. We find that regional and US factors do not explain liquidity variations in all the markets that exhibit low sensitivity to external factors. Our results are robust to the use of alternative proxies. The analysis in sub-periods confirms our results showing that most markets are not very sensitive to fluctuations and external shocks of liquidity. For international investors, stock markets in the Middle East and North Africa present an opportunity for further diversification, as these markets exhibit weak correlations between them and with the global market with regard to liquidity.     

The federal funds market,excess reserves,and unconventional monetary policy

Following the bankruptcy of Lehman Brothers, interbank borrowing and lending dropped, whereas reserve holdings of depository institutions skyrocketed, as the Fed injected liquidity into the U.S. banking sector. This paper introduces bank liquidity risk and limited market participation into a real business cycle model with ex ante identical financial intermediaries and shows, in an analytically tractable way, how interbank trade and excess reserves emerge in general equilibrium. Investigating the role of the federal funds market and unconventional monetary policy for the propagation of aggregate real and financial shocks, I find that federal funds market participation is irrelevant in response to standard supply and demand shocks, whereas it matters for “uncertainty shocks”, i.e. mean-preserving spreads in the cross-section of liquidity risk. Liquidity injections by the central bank can absorb the effects of financial shocks on the real economy, although excess reserves might increase and federal funds might be crowded out, as a side effect.     

House price appreciation, liquidity constraints, and second mortgages

This paper analyzes how households use second mortgages in response to shocks to housing wealth. Two related questions are examined: Do households use home equity in response to house price appreciation? Are liquidity constraints important for homeowners? A theoretical model shows that liquidity-constrained households respond more strongly to house price changes than unconstrained households. Using PSID, I find noteworthy differences in borrowing patterns of homeowners by the ratio of wealth to income. Low wealth-to-income homeowners exhibit a strong reaction to house price appreciation, whereas high wealth-to-income ones do not. The results indicate the importance of liquidity constraints among homeowners.     

Impact of leveraged ETF trading on the market quality of component stocks

We investigate the effect of leveraged ETF trading on the trading activity and market quality of their component stocks. The results show that both quoted and effective spreads of component stocks increase about 0.2–3.0 basis points after the inception of leveraged ETFs, while other liquidity measures do not show significant changes. The trading volume of component stocks is positively and significantly correlated with the trading volume of leveraged ETFs, but the volatility of component stocks is not affected by ETF trading either at the daily level or during the last hour of trading. In addition, the volatility of component stocks decreases slightly after ETF inception. These findings do not support the previous claim that the trading of leveraged ETFs increases price volatility of component stocks.     

Emergence of a core-periphery structure in a simple dynamic model of the interbank market

This paper studies a simple dynamic model of interbank credit relationships. Starting from a given balance sheet structure of a banking system with a realistic distribution of bank sizes, the necessity of establishing interbank credit connections emerges from idiosyncratic liquidity shocks. Banks initially choose potential trading partners randomly, but over time form preferential relationships via an elementary reinforcement learning algorithm. As it turns out, the dynamic evolution of this system displays a formation of a core-periphery structure with mainly the largest banks assuming the roles of money center banks mediating between the liquidity needs of many smaller banks. Statistical analysis shows that this evolving interbank market shares the majority of the salient characteristics of interbank credit relationship that have been put forth in recent literature. Preferential interest rates for borrowers with strong attachment to a lender may prevent the system from becoming extortionary and guarantee the survival of the small peripherical banks.     

Does algorithmic trading harm liquidity? Evidence from Brazil

This paper provides the first evidence of algorithmic trading (AT) reducing liquidity in the Brazilian equities market. Our results are contrary to the majority of work which finds a positive relationship between AT and liquidity. Using the adoption of a new data center for the B3 exchange as an exogenous shock, we report evidence that AT increased realized spreads in both firm fixed-effects and vector autoregression estimates for 26 stocks between 2017 and 2018 using high-frequency data. We also provide evidence that AT increases commonality in liquidity, evidencing correlated transactions between automated traders.     

Liquidity skewness premium

Risk-averse investors may dislike decrease of liquidity rather than increase of liquidity, and thus there can be asymmetric preference in variation of liquidity. In addition, investors are likely to avoid extreme illiquidity. This paper examines whether the skewness of an individual firm’s liquidity capturing asymmetric distribution of liquidity and extreme illiquidity is priced in the US stock market. Using the skewness of the daily price impact, we find that it is positively priced, and this positive relation is significant up to eight months after controlling for other effects. Moreover, we find our results remain significant with the skewness of alternative liquidity measures, i.e., dollar-volume, and turnover.     

The impact of reduced pre-trade transparency regimes on market quality

This paper studies the effects of pre-trade quote transparency on spread, price discovery and liquidity in an artificial limit order market with heterogeneous trading rules. Our agent-based numerical experiments suggest that full quote transparency incurs substantial transaction costs to traders and dampens trading activity in an order-driven market. Our finding reveals that exogenous restriction of displayed depth, up to several best quotes, does not benefit market performance. On the contrary, endogenous restriction of displayed quote depth, by means of iceberg orders, improves market quality in multiple dimensions: it reduces average transaction costs, maintains higher liquidity and moderate volatility, balances the limit order book, and enhances price discovery.     

An agent-based model of payment systems

We lay out and simulate a multi-agent, multi-period model of an RTGS payment system. At the beginning of the day, banks choose how much costly liquidity to allocate to the settlement process. Then, they use it to execute an exogenous, random stream of payment orders. If a bank's liquidity stock is depleted, payments are queued until new liquidity arrives from other banks, imposing costs on the delaying bank. We study the equilibrium level of liquidity posted in the system, performing some comparative statics and obtaining insights on the efficiency of alternative system configurations.     

流动性过剩的测度方法与实证分析

流动性过剩是指实际的广义货币供应量显著地多于有效经济产出所需要的货币数量。本文以此为基础,设计流动性总量过剩系数(CTEL)和流动性增量过剩系数(CAEL)为测度指标,提出流动性过剩与否的判断标准;运用流动性总量过剩系数,选取相关样本数据进行实证分析,结果表明:从2006年第1季度到2007年第2季度,我国均存在流动性过剩,流动性总量过剩系数的平均值高达0.229,相当于名义货币平均过剩6.18万亿元,实际货币平均过剩5.34万亿元。     

Liquidity constrained exporters

I propose a model of international trade with liquidity constraints. If firms must pay a fixed entry cost in order to access foreign markets, and if they face liquidity constraints to finance these costs, only those firms that have sufficient liquidity are able to export. A set of firms could profitably export, but are prevented from doing so because they lack sufficient liquidity. More productive firms that generate large liquidity from their domestic sales, and wealthier firms that inherit a large amount of liquidity, are more likely to export. This model offers a potential explanation for the apparent lack of sensitivity of exports to exchange rate fluctuations. When the exchange rate appreciates, existing exporters lose competitiveness abroad, and are forced to reduce their exports. At the same time, the value of domestic assets owned by potential exporters increases. Some liquidity constrained exporters start exporting. This dampens the anti-competitiveness impact of a currency appreciation. Under some conditions, it may reverse it altogether and increase aggregate exports. In this sense, the model is able to rationalize the co-existence of competitive devaluations and competitive revaluations.     

Funding liquidity risk and the low-volatility anomaly: Evidence from the Taiwan stock market

We investigate whether the funding liquidity risk to institutional investors influences the negative relation between expected returns and variance (the ‘‘Low-volatility anomaly’’). With the Taiwan stock market as a setting, we implement a multivariate Markov switching model and use the funding liquidity risk to model the time-varying transition probabilities of the regime-switching process to capture changes in the funding liquidity risk regime. Our evidence documents that the low-volatility anomaly is most pronounced when there is high funding liquidity risk. When there is low funding liquidity risk, however, the low-volatility anomaly has a significant reversal. These results imply that the increased funding liquidity risk due to financial shock transmitted from parent banks is associated with higher selling pressure on institutional investors’ high-volatility stocks, leading to the low-volatility anomaly.     

European quanto option pricing in presence of liquidity risk

In this paper, we study the pricing problems of the European quanto options in which the underlying foreign asset is in imperfectly liquid markets. First, we assume that the dynamics of the underlying foreign asset price are affected by market liquidity and propose a liquidity-adjusted quanto model. This allows for the effects of market liquidity on European quanto option pricing. And then we derive the analytical pricing formulas for four different types of European quanto options. Finally, we empirically investigate the pricing performance of our proposed model with a European quanto construction involving the SSE 50 ETF, as the underlying asset, and the CNY/HKD exchange rate. Empirical results demonstrate that the pricing accuracy of the proposed model is markedly superior to that of the Black-Scholes quanto model. In other words, allowing for liquidity risk in the framework of European quanto option pricing can make markedly improvements in fitting the real market data. Particularly, the improvement rate is high for medium-term and out-of-the-money options. Moreover, these results are robust for different liquidity measures.