Through stormy seas: how fragile is liquidity across asset classes and time?

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

Market liquidity across asset classes has considerably increased in recent decades. Our study of stocks, foreign exchange (FX), and government bonds in the US, Europe, and Japan - using 25 years of high-frequency data - reveals a significant decline in both the average and standard deviation of bid-ask spreads across all asset classes. However, we also observe an increase in its skewness and kurtosis in equity and bond markets, indicating more frequent episodes of illiquidity. In contrast, FX markets do not show a significant increase in the higher moments of the distribution of bid-ask spreads. We identify structural breaks in the time series of spread distributions across regions and asset classes, associate these breaks with macroeconomic shocks and changing market conditions, and quantify the cost of this fragility to investors.

JEL classification: G10, G12, G14

Keywords: liquidity, market resiliency, high frequency trading, fragmentation