Through stormy seas: how fragile is liquidity across asset classes and time?
(November 2024, revised April 2026)
Summary
Focus
We analyse the evolution and resilience of market liquidity across key asset classes – stocks, foreign exchange (FX) and government bonds – in major developed markets (United States, Europe and Japan) over the past 25 years. We do not focus simply on the first moment (mean) but include the higher moments (standard deviation, skewness and kurtosis) of the bid-ask spread. By looking at the distribution, we gain insights into the complex dynamics and resilience of liquidity in these markets. We also explore the potential drivers behind observed changes in the distribution of liquidity and their implications for traders and markets.
Contribution
Our paper significantly advances the understanding of market liquidity by extending beyond average liquidity levels to examine higher moments of the liquidity distribution. This unique focus reveals an increase in episodes of substantial illiquidity despite overall improvements in average liquidity. Furthermore, we highlight the dual impact of algorithmic trading and market fragmentation, showing that while these factors reduce average spreads, they are also associated with a reduction in market resilience, as measured by an increase in the skewness of bid-ask spreads.
Findings
While the average bid-ask spread has significantly declined across stock, foreign exchange and government bond markets over the past 25 years, indicating improved average liquidity, the higher moments of the distribution (skewness and kurtosis) have increased in equity and bond markets. This suggests more frequent episodes of substantial illiquidity, highlighting increased market fragility. In contrast, FX markets have reduced the spread without a corresponding increase in illiquidity episodes. We identify structural breaks in the time series of spread distributions and associate them with macroeconomic shocks and changing market conditions. Additionally, we find algorithmic trading and market fragmentation tend to lower average spreads but increase skewness, particularly in equity markets, underscoring the dual impact of these factors on market liquidity and vulnerability. Lastly, our simulation exercise suggests that a higher skewness of the bid-ask spread can directly undermine trading profits.
Abstract
Liquidity has improved across global markets, yet concerns have grown about its increasing fragility. We study the distribution of bid-ask spreads across equities, bonds, and foreign exchange (FX) in the US, Europe and Japan. Although average spreads have declined since the 1990s, skewness has increased in bond and most equity markets, but not in FX. Increased skewness is driven by greater improvements in liquidity during normal time than during stress periods. We identify structural breaks in means and skewness, map them to macroeconomic events, market structure changes, and regulatory reforms, and study their determinants. Simulations show that higher skewness substantially increases trading costs.
JEL classification: G10, G12, G14
Keywords: liquidity, market resiliency, high frequency trading, fragmentation
