Liquidity-soaked bond and share traders have never had it so good but apparent still waters obscure the growing risk of destructive rogue waves, a new academic paper suggests.
The Bank of International Settlements (BIS) study found bid-ask spreads in various asset classes have narrowed consistently over time, implying improved liquidity and trading conditions.
But the focus on average market liquidity data misses the impact of statistical extremes – as measured by kurtosis and skewness – that paint a more nuanced investment weather report.
“While trading has become easier than ever, with spreads narrowing significantly, illiquidity episodes are now more frequent than in the past in many asset classes,” the paper says.
In fact, only foreign exchange traders seem to have benefited unequivocally from the double-whammy of tighter spreads and normal skewness.
Fixed income and equity markets across the US, Europe and Japan all show the pattern of generally improving liquidity interrupted with more frequent statistical outliers.
The ‘Through stormy seas: how fragile is liquidity across asset classes and time?’ study says several incidents such as the 2010 ‘flash crash’ have shown that a sudden freeze can especially unsettle markets used to easy-trading.
“In financial markets, there are episodes where market liquidity vanishes abruptly, leaving traders unable to execute orders quickly or at prevailing prices,” the study says. “These episodes can be especially problematic if market participants have become accustomed to consistently high levels of liquidity, thereby amplifying the shock of its sudden absence.”
Authored by a quartet of academics – Nihad Aliyev, Matteo Aquilina, Khaladdin Rzayev and Sonya Zhu – the analysis suggests the increasing risk of out-of-the-blue illiquidity events can “significantly erode” returns.
“… our results show that while markets are now on average much more liquid than in the past, they are also more subject to episodes of illiquidity in many cases. Metaphorically, market participants are navigating a sea that is often much calmer than in the past but one that is also increasingly prone to sudden and significant storms.”