Why Market Structure and Liquidity Matter

A Report in the US Equity Market Structure Analysis Series

In a post-Reg NMS world, one unintended consequence is the rise of fragmentation, complicating equity market structure & leading market participants to wonder if changes are necessary. Market structure matters as it can drive liquidity and trade costs. As such, market participants continually strive to create the most efficient markets. Inside this note we assess:

Liquidity & Trade Costs: Market liquidity is the ability to efficiently buy/sell securities without causing a substantial change in the price of the asset and is important as it impacts trade costs and therefore affects returns to investors.
Market Landscape: When routing an order, whether directly to an exchange or executed off-exchange, firms balance likelihood of execution against price/size improvement. (Also includes a look at market participants.)
Role of Market Makers: Market makers exist to provide liquidity in securities and execute trades, playing an important role in equity market structure by enabling the smooth flow of markets.

Executive Summary

In a post Regulation National Market System (NMS) world, one unintended consequence is the rise of fragmentation, perhaps too much fragmentation given there are now 16 exchanges, 33 alternative trading systems (ATS), and multiple over-the-counter (OTC) venues. This forces traders to balance the likelihood of certainty of execution against potential price and size improvement and other transaction costs when choosing an execution venue. As such, this has complicated U.S. equity market structure, leading market participants to wonder if changes are necessary.

Market structure can drive liquidity and trade costs. Therefore, market participants continually strive to create the most efficient markets. This includes adapting new technologies to achieve operational efficiencies, searching for new ways to transact and, generally, sculpting market structure to maximize efficiencies. In this note, we look at how market structure matters to achieving high levels of market liquidity and minimizing trade costs.

Market Liquidity – Market liquidity is the ability to efficiently buy or sell securities without causing a substantial change in the price of the asset (stable prices), as measured by speed and ease of execution. Markets need robust trading volumes to remain liquid, as liquidity is tied to price volatility. Wide swings in prices can limit demand for the securities, keeping volumes depressed. Lower volumes lead to increased time to execute a trade and wider bid-ask spreads – a measure of market liquidity – which increases costs to trade.

Trade Costs – Market liquidity is important as it impacts the costs to trade and therefore affects returns to investors. Higher spreads lead to higher transaction costs which cut into an investor’s return. Total trade costs can be split into: explicit (broker commissions, market access fees, transaction costs, clearing and settlement costs, taxes) and implicit (bid-ask spreads, opportunity cost, price impact of a trade).

Order Routing – Fragmentation in U.S. equity markets forces traders to balance the likelihood of execution against potential price and size improvement and other transaction costs when choosing an execution venue. Traders must balance the cost of not filling the order with the potential for price or size improvement. Firms have built technologies to address market fragmentation and seek out hidden liquidity to achieve best execution of trades on behalf of their clients. When routing an order, a broker can either send the order directly to an exchange (on exchange) or it can execute institutional and retail trades on a bilateral basis (off exchange).

Market Participants – Capital markets connect those needing capital (corporations) with providers of capital (investors). These relationships are facilitated by various financial institutions and equity exchanges: listing and trading exchanges; off-exchange venues; short-term holders of stocks; and liquidity providers.

Market Makers – Market makers must make two-sided markets at all times, no matter what the market environment. Even when markets become volatile or fall under extreme stress, market makers must continue facilitating the flow of liquidity in markets. In short, market makers play an important role in U.S. equity market structure by enabling the smooth flow of markets.

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