The Ups And Downs Of Market Liquidity

And the different ways both specialists and electronic exchanges affect it

Liquidity is a slippery concept. The New York Stock Exchange says its specialists provide the most liquidity, and that dispersing trading in NYSE stocks would be bad for everyone. Electronic marketplaces like Archipelago Exchange, Instinet, and Island say their systems are highly liquid. But the debate is confused. Steps that increase liquidity in certain circumstances could dry it up in others. Here's a primer:

What is liquidity?

It's the ability to buy or sell assets quickly without affecting their price. An asset is "liquid" if you can turn it into cash quickly and still get a good price for it.

What about liquidity in stocks?

Liquidity takes on two very different appearances depending on whether markets are calm or in crisis. In calm markets, liquidity is something that pleases traders by reducing how much prices move against them when they buy or sell. In contrast, when a market suffers a crisis, such as major bad news, liquidity is what keeps trading from drying up entirely. By stepping in to buy when others won't, "liquidity providers" can quell panic that makes it impossible to sell at any price.

Explain calm-market liquidity first.

For small investors, it's mostly about what traders call "narrow spreads." Middlemen make profits by buying shares at a low price and selling them at a higher price. Competition narrows that gap -- or spread -- so more of the benefits of trading go to the customers than to the middlemen. Big investors also care about rapid execution of their trades, since often they try to profit from short-term price fluctuations.

And they care about "market depth." Markets are deep when it's possible to buy lots of shares in a short period without causing a shortage that forces the price up, or to sell without flooding the market and forcing the price down.

Does liquidity dry up in calm markets when trading gets split up among many venues?

You would think so. But research by Roger D. Huang, finance professor at the University of Notre Dame's Mendoza College of Business, shows that spreads between the highest bids and lowest offers on NASDAQ stocks have narrowed since electronic communications networks (ECNS) began competing with NASDAQ market makers. Often, he reported in a study in the Journal of Finance last year, it's the ECNs that post the best prices. And Huang believes it's still possible to buy and sell large blocks of stock efficiently by splitting orders up among multiple trading venues.

So who needs the NYSE specialists and the NASDAQ market makers?

In calm markets, they're probably not essential. But they play a crucial role when markets suffer a shock. NYSE specialists are obligated to maintain orderly markets when prices are falling by buying shares with their own money. NASDAQ market makers are also supposed to post bids as well as offers for the shares they trade at all times, although their obligations are less stringent.

How can a handful of specialists and market makers make any difference?

Think of them as levers for the Federal Reserve, which is the lender of last resort in crises. In 1987, the Federal Reserve was worried that the October stock market crash would touch off a wave of defaults and damage the entire economy. To get the market functioning again, it urged big banks to lend money to technically insolvent specialists and market makers so that they could continue trading, says Douglas W. Diamond, finance professor at the University of Chicago's Graduate School of Business. In turn, the Fed promised the banks they could borrow from it without restraint.

Couldn't the Fed do the same thing with electronic communications networks?

No, because ECNs simply match buyers and sellers, without trading for their own accounts. If markets seized up, the Fed would not know where to direct loans to re-liquefy potential buyers and restart markets.

So, what should be done?

The people who are redesigning markets with an eye toward improving calm-market liquidity should keep in mind the importance of maintaining liquidity in times of crisis. That may mean preserving some of the rules that allow NYSE specialists to be profitable, such as the trade-through rule, which requires orders to flow to the NYSE if its specialists are providing the best price. Take away the specialists' profits, and they may not be around the next time a crisis strikes.

By Peter Coy in New York

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