Liquidity and the market maker – inseparable twins

by **Cals** Mon 22 Feb 2016, 03:20

Saturday, 20 February 2016

Liquidity and the market maker – inseparable twins

BY SURESH RAMANATHAN CURRENCY INSIGHTS

LIQUIDITY is a multi-dimensional concept which generally refers to the ability to execute large transactions with limited price impact and tends to be associated with low transaction costs and immediacy in execution.
In some markets such as foreign exchange, fixed income and derivatives where matching supply and demand for a given instrument becomes challenging, market makers, such as banks and trading firms are essential in providing liquidity and facilitating transactions by stepping in as counterparties to such transactions.
This involves buying or selling financial instruments without an immediate matching transaction and it requires market makers to bear risks relating to the movement in inventory values.
But still, liquidity conditions can differ significantly across different asset classes, more so in the current environment. Financial assets with lower levels of liquidity tend to have higher liquidity risk premia and market participants tend to face higher transaction costs and wider bid-ask spreads when trading in these instruments.

Some the salient features of liquidity to be noted are depth and resilience, tightness and immediacy.
A market is deep and resilient when there is a large flow of trading orders on both the buy and sell side on a frequent basis as well as a constant interest and willingness to trade.
With large orders in both directions, trading volumes should be high and the price impact of larger trades should be lower, creating lower volatility and resiliency.
In the case of tightness it typically refers to the financial cost of completing a transaction, which is encapsulated by the bid and ask spreads. As spreads widen, market participants would view it as less tight scaling back their decision on willingness to trade.
Immediacy on the other hand typically refers to the time it takes to complete a transaction. Market makers are a constant source of immediacy.
Under an agency trading system, finding a trading match or partner depends on frequency of transactions and constant depth of trading interest in the security by investor.
But how is liquidity provided in financial markets? Though it is dependent on the characteristics of the underlying assets and the market structure. Three key approaches are notable.
In an order-driven market, buyers and sellers display the prices at which they are willing to buy or sell financial instruments and the amount they are willing to buy and sell at those prices.
The presence of multilateral trading venues, such as exchanges eases the process of matching supply and demand for instruments that are sufficiently numerous and standardised.
Trading on multilateral venues enable participants to trade standardised contracts which tend to be linked to clearing facilities via central counterparties (CCPs).
Liquidity in these markets is therefore provided by high levels of supply and demand from individuals, institutions and brokers on their behalf, which generates continuous two-way trading interest. This typically generates large volumes of outstanding orders in these markets.
The price action in these markets are fast and furious and movements are at times difficult to be gauged via fundamental factors but instead flows will be the main catalyst.
In quote-driven markets such as fixed income, foreign exchange, commodities and derivatives markets, transactions are concluded on the basis of quotes that are provided by market makers to market participants. These quotes are typically made available on a continuous basis to participants that are valid for a point in time and continuously adjusted.
Providers of quotes on a continuous basis have to bear risk in relation to any price movements in between buying and selling assets and therefore commit capital to support the provision of liquidity in these markets.
In this way dealers improve markets with poor underling market transaction activity with enhanced liquidity in terms of both immediacy and depth.
It’s a natural way of trading and dealing that currently occurs in most Malaysian Investment banks Treasury departments.
Request for quote (RFQ) markets is when quotes are provided to buyers and sellers on request either electronically or by voice negotiation, such as in fixed income and non-exchange traded derivatives.
In RFQ markets, market makers provide liquidity and price quotes that are valid for a point in time where there is not sufficient continuous buying and selling interest to support an order-driven model with acceptable rates of matching.
This approach in providing liquidity is a feature that is entrenched in Malaysia’s fixed income and foreign exchange market. It is also the main approach of the price discovery process particularly when one trades the Ringgit at the opening levels in the morning session.
A key denominator in all three approaches in providing liquidity in financial markets is the role that is played by the market maker. For a market maker, be it in foreign exchange, fixed income, derivatives and commodities, the key consideration would be dependent on the rate of transactions.
Fewer transactions would result in low fee income and would mean that surplus inventory may have to be held for longer on balance sheet thus exposing the market maker to changes in the underlying value of the security.
Another significant consideration would be the level of market maker’s risk aversion that impacts the tolerance towards absorption of risky financial instrument inventory.
For a given risk level of a financial instrument, higher risk aversion will make it more likely that a market maker will not trade that particular financial instrument.
Suresh Ramanathan is an Independent Interest Rate and FX Strategist. He can be contacted at skrasta70@hotmail.com