1.IV.7 Liquidity

Liquidity is generally considered to be one of the most important – if not the most – important feature of a well-functioning financial market.1 MiFID I introduced a definition of ‘liquid shares’ and a ‘liquid market’.2 MiFID II/MiFIR has introduced additional provisions referring to liquidity.3 These definitions are quite static and do not really say what liquidity is. Thankfully, the Commission has provided an interpretation. The Commission describes liquidity as follows:

‘Liquidity is a complex concept that is used to qualify the markets and the instruments traded on these markets. It aims at reflecting how easy or difficult it is to buy or sell an asset, usually without affecting the price significantly. Liquidity is a function of both volume and volatility. Liquidity is positively correlated to volume and negatively correlated to volatility. A stock is said to be liquid if an investor can move a high volume in or out of the market without materially moving the price of that stock. If the price moves in response to investment or disinvestments, the stock becomes more volatile’.4

The description of the Commission shows that liquidity is a complex, but essential, feature in ensuring an efficient allocation of capital. A high degree of equity pre- and post-trade transparency is overall associated with supporting liquidity based on the advantages of pre- and post-trade transparent equity markets. A high degree of equity pre- and post-trade transparency can support liquidity, among other things, by facilitating so-called price discovery, reduced search costs, and through providing an overview of trading in the situation where liquidity is fragmented5 across multiple venues.6

A high degree of equity pre- and post-trade transparency ‘can’ support liquidity, because too much transparency can also harm liquidity provision. The description of the Commission shows why the degree of equity pre- and post-trade transparency differs depending on the liquidity available in a given market. An order has more so-called market impact in a less liquid market,7 whereas the costs of market impact reduce in a highly liquid market.8 For example, the publication of potential trading interest of a large equity order (equity pre-trade data) will result in more volatility - and accordingly more market impact (price shocks).9 Another example where the degree of equity pre- and post-trade transparency adapts to the liquidity available, is where liquidity is mainly provided by investment firms that take temporary risk positions. Too high equity pre- and post-trade transparency might discourage the provision of such liquidity, since the investment firm wants to rebalance its position in the near future. Too high equity post-trade transparency could especially harm such liquidity provision. This is because - based on the equity post-trade data published - other market participants can take harmful trading positions relative to the investment firm wanting to balance the temporary risks (inventory risk).10

The challenge is ensuring a degree of equity pre- and post-trade transparency that supports an optimal amount of liquidity. Relevant aspects are the (1) the liquidity of the financial instrument and (2) the type of market participants involved. Generally speaking, liquid markets (e.g. ‘blue-chip’ shares) are associated with a higher degree of equity pre- and post-trade transparency.11 Where liquidity drops, investment firms providing liquidity, including so-called liquidity providers,12 become more important. As a generalisation, liquidity providers prefer not disclose their own position in light of inventory risk/keep their informational advantage, but still want to observe pre- and post-trade data of others.13