Commonality in liquidity

Abstract

Traditionally and understandably, the microscope of market microstructure has focused on attributes of single assets. Little theoretical attention and virtually no empirical work has been devoted to common determinants of liquidity nor to their empirical manifestation, correlated movements in liquidity. But a wider-angle lens exposes an imposing image of commonality. Quoted spreads, quoted depth, and effective spreads co-move with market- and industry-wide liquidity. After controlling for well-known individual liquidity determinants, such as volatility, volume, and price, common influences remain significant and material. Recognizing the existence of commonality is a key to uncovering some suggestive evidence that inventory risks and asymmetric information both affect intertemporal changes in liquidity.

Introduction

The individual security is the traditional domain of market microstructure research. Topics such as transactions costs and liquidity naturally pertain to the repeated trading of a single homogeneous asset. Typically, we do not think of such topics in a market-wide context, except perhaps as averages of individual attributes.

From the earliest papers (Demsetz, 1968; Garman, 1976), the bid–ask spread and other microstructure phenomena have been modeled with an isolated market maker in the pivotal role, providing immediacy at a cost determined by either inventory risks from a lack of diversification (Stoll, 1978a; Amihud and Mendelson, 1980; Grossman and Miller, 1988), or by the specter of asymmetric information (Copeland and Galai, 1983; Glosten and Milgrom, 1985). Privileged information has pertained to an individual stock, the insider serving as prototype privilegee (Kyle, 1985; Admati and Pfleiderer, 1988).

Empirical work also deals solely with the trading patterns of individual assets, most often equities sampled at high frequencies (Wood et al., 1985; Harris, 1991), or examines micro questions such as the price impact of large trades (Kraus and Stoll, 1972; Keim and Madhavan, 1996; Chan and Lakonishok, 1997). The single-asset focus is exemplified by a prominent recent paper (Easley et al., 1997), whose empirical work is devoted to a single common stock, Ashland Oil, on thirty trading days.

Even articles devoted to market design (Garbade and Silber, 1979; Madhavan, 1992) examine the influence of various trading mechanisms solely on the costs of individual transactions. Studies of topics such as intermarket competition, or the contrast between dealer and auction markets, yield predictions about individual liquidity and transaction costs.

We do not imply even the slightest criticism. The microstructure literature has indeed become a very impressive body of knowledge. But in this paper we aspire to direct attention toward unexplored territory, the prospect that liquidity, trading costs, and other individual microstructure phenomena have common underlying determinants. A priori reasoning and, as it turns out, sound empirical evidence suggest that some portion of individual transaction costs covary through time.

Since completing the first draft of this paper, two other working papers with similar results have appeared; see Hasbrouck and Seppi (1998) and Huberman and Halka (1999). Given the virtual absence of documented commonality in the existing literature, this sudden flurry seems to portend a shift of emphasis from individual assets to broader market determinants of liquidity.

Commonality in liquidity could arise from several sources. Trading activity generally displays market-wide intertemporal response to general price swings. Since trading volume is a principal determinant of dealer inventory, its variation seems likely to induce co-movements in optimal inventory levels which lead in turn to co-movements in individual bid–ask spreads, quoted depth, and other measures of liquidity. Across assets, inventory carrying costs must also co-move because these costs depend on market interest rates.

The risk of maintaining inventory depends also on volatility, which could have a market component. Program trading of simultaneous large orders might exert common pressure on dealer inventories. Institutional funds with similar investing styles might exhibit correlated trading patterns, thereby inducing changes in inventory pressure across broad market sectors. Whatever the source, if inventory fluctuations were correlated across individual assets, liquidity could be expected to exhibit similar co-movement.

One might think that little covariation in liquidity would be induced by asymmetric information because few traders possess privileged information about broad market movements. In the prototypical case of a corporate insider, privileged information is usually thought to pertain only to that specific corporation. Indeed, this presumption would be valid for certain types of information, such as fraudulent accounting statements. However, there might be other types of secret information, such as a revolutionary new technology, that could influence many firms, not necessarily all in the same direction. Within an industry, occasional occurrences of asymmetric information could affect many firms in that sector.

Covariation in liquidity and the associated co-movements in trading costs have interesting ramifications and pose immediate questions. A key research issue is the relative importance of inventory and asymmetric information. Of equal interest would be other potential sources of commonality, as yet unimagined. How are these causes themselves related to market incidents such as crashes? Does their influence depend on market structure or design?

There are practical implications of the commonality issue for traders, investors, and regulators. For example, sudden pervasive changes in liquidity might have played a key role in otherwise puzzling market episodes. During the summer of 1998, the credit-sensitive bond market seemed to undergo a global liquidity crisis. This event precipitated financial distress in certain highly leveraged trading firms which found themselves unable to liquidate some positions to pay lenders secured by other, seemingly unrelated positions.¹ Similarly, the international stock market crash of October 1987 was associated with no identifiable noteworthy event (Roll, 1988), yet was characterized by a ubiquitous temporary reduction in liquidity.

Trading costs should be cross-sectionally related to expected returns before costs simply because after-cost returns should be equilibrated in properly functioning markets (Amihud and Mendelson, 1986; Brennan and Subrahmanyam, 1996). But commonality in liquidity raises the additional issue of whether shocks in trading costs constitute a source of non-diversifiable priced risk. If covariation in trading costs is cannot be completely anticipated and has a varying impact across individual securities, the more sensitive an asset is to such shocks, the greater must be its expected return. Hence, there are potentially two different channels by which trading costs influence asset pricing, one static and one dynamic: a static channel influencing average trading costs and a dynamic channel influencing risk. In future work, it would be of interest to determine whether the second channel is material and, if so, its relative importance.

This paper is devoted mainly to documenting the commonality in liquidity, measuring its extent, and providing some suggestive evidence about its sources. However, the precise identification of these sources remains for future research. Section 2 describes the data. Section 3 reports a progression of empirical findings about commonality in liquidity. Section 4 provides some interpretations, makes suggestions for additional empirical research, calls on theorists for help, and concludes.