The evolution of equity markets has lowered spreads and boosted liquidity, but these gains have come at the expense of increased market fragility, according to new research from the Bank for International Settlements (BIS).
In a working paper published Friday, researchers examined liquidity conditions in the world’s largest equity, government bond and foreign exchange (FX) markets across Europe, the U.S. and Japan over the past 25 years.
“Our findings show that modern financial markets are, on average, significantly more liquid than they were 25 years ago, with bid-ask spreads having declined substantially over this period,” the paper said, adding that, while the size of these shifts vary by asset class and geography, the overall decline in trading spreads is “notable.”
However, the researchers also found that the increased average liquidity in equity and bond markets have also been accompanied by “more frequent episodes of illiquidity.”
And, as this increased liquidity has proven more flighty, this also negatively impacted trading profits.
“Specifically, increasing skewness by about 50% — a change similar to that observed in stock markets — while keeping the mean and standard deviation constant, reduces the trading profitability of a simple strategy, which involves buying at the lowest ask price and selling at the highest bid price each day, by approximately 7.2%,” the researchers reported.
They also noted that episodes of sharply reduced liquidity “can be especially problematic if market participants have become accustomed to consistently high levels of liquidity, thereby amplifying the shock of its sudden absence.”
“Taken together, 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,” the paper said.
“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.”
According to the paper, in equity markets, the tightening of spreads and higher average liquidity has been associated with increases in algorithmic and high-frequency trading, as well as increased market fragmentation.
However, the researchers didn’t observe the same kind of increase in market fragility in the FX markets, even as algo/high-frequency trading increased there too.
“Given the potentially severe consequences associated with these episodes it is important to understand how they can be mitigated. FX markets, where average spreads declined but skewness has not increased, could provide clues on effective mitigants,” they suggested.
The researchers theorize that one reason for the higher resilience of the FX markets may reflect the “unique nature of automation” in these markets, where banks have automated execution but trading decisions remain the turf of human traders, which serves as a balance with non-bank trading that has been fully automated.
“Additionally, FX markets have adapted swiftly to mitigate the impact of [high frequency trading] through measures such as ‘speed bumps’ introduced by major players and trading venues in 2013-2014,” the paper said, noting that this may have made FX markets “less susceptible to aggressive HFT activities compared to equity markets.”