Wednesday, May 11, 2011

Can less liquidity on an exchange be beneficial ?

Well friends, I am one of those who believes that more the liquidity on an exchange- better it is for the exchange. It helps get more business, more volumes and thus more revenues for an exchange- in terms of getting more transaction tax - if more volumes.

But, can an exchange benefit if the liquidity is too less ?

Naturally, by common sense - one would say that less liquidity is killer for an exchange. But there can be some circumstances where it can be asset.

Let us look at one such circumstance.

Let us suppose we have 2 exchanges. On first one (A) - we have huge liquidity- almost 90% liquidity. Remaining 10% is with exchange (B).

Now, if 2 parties have to do a block trade - which one would be a better place to do it ?
Well, it will not be A, but rather the exchange B. The reason is as follows -

On exchange B, since the liquidity is less, the prices would not move fast- so an intermediary involved in block trade would sell stocks for one party and simultaneously buy stocks for another party. Since exchange B is not so liquid, the intermediary can protect prices for the 2 parties involved in block trade and would be in a better position in getting the buy and sell prices for these 2 parties.

Now, what would have happened had we done this on exchange A:

Since A is highly liquid (90%) and so the bid- ask spread are very tight, it would mean that if a huge buy order is placed, it would be absorbed very quickly from ASK side and similarly if a sell order is placed, again it would be absorbed very quickly from BID side. So movement will be very quick as liquidity is high on both bid and ask side. So, problem is that - for an intermediary, as soon as he buys it, there may be someone on other side who comes and sell all its stock at a very huge price and so the intermediary may suffer losses. And so conducting a block trade can become a challenge because your average buy may not match up very well with your average sell price.

Such a condition would have very less chances to arrive at exchange B- reason being that due to less liquidity, spreads would be far and there would be less players trying to game this exchange. So if intermediary is buying a huge stock, it would have less chances to get someone who sells a huge stock. So on a less liquid exchange, intermediary can buy for one party and simultaneously sell for another party and very well ensure that these trades match up and so the two parties can do block trade with quite stable prices while using an intermediary.

This way the buy and sell prices can be somewhat protected and we can do a much better block trade compared to exchange A.

I hope I have made my point. Any comments in this regard are appreciated.

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Sushant Alevoor said...

Here are my thoughts on this:

Firstly, block trades are usually executed bilaterally through OTC counters or through block trading facilities of exchanges. Since they do not fall into the public domain, a question of liquidity does not arise

Secondly, I would prefer to execute a high volume trade on a highly liquid exchange. The thinking on this one is like this: a highly liquid exchange usually has huge demand and supply. Hence any big order would not significantly alter the demand or the supply so as to increase the volatility of the stock traded in. An analogy would be "pouring or taking a bucket of water from the ocean". A real world example is the forex market where huge trades are executed without significant alteration of prices

Let me know if I am missing something. Your comments are welcome


Ankit Arora said...

You are very right Sushant.
Many thanks for your comment...

But the way I had written the article was to convey the idea where even v low liquidity can be beneficial for an exchange. The points you have mentioned are absolutely right and I want to put more viewpoints here.

Regarding your point#1 :

Yes, block trades do happen OTC, but there are also cases when they have to be done on an exchange. In that case you should execute it on a less liquid exchange. Since an exchange which is very illiquid, it would act as an OTC- or rather a kind of dark pool. And so an intermediary can do this block trade- where the intermediary will buy for one party and simultaneously see for other party and conduct the block...

Reg point#2 :
Yes, as a trader - i would prefer a high liquid environment. but I would prefer it when I do normal buy or sell. If I am involved in a block trade on behalf of 2 parties, I would not go for highly liquid exchange

Ankit Arora