Kee H. Chunga and Chairat Chuwonganant
Uncertainty, market structure, and liquidity
Journal of Financial Economics | Volume 113, Issue 3 (September 2014), 476-499

It is well known that the liquidity of individual assets tends to move together. Liquidity co-movements could arise because liquidity providers share common capital and information and thus respond similarly to outside shocks. Liquidity commonality could also arise from the trading behavior of liquidity demanders. Our study sheds light on the cause of liquidity commonality by analyzing the relation between market uncertainty and liquidity.

We show that market uncertainty [measured by the Chicago Board Options Exchange Market Volatility Index (VIX)] exerts a large market-wide impact on liquidity, which gives rise to co-movements in individual asset liquidity. Our study also shows that the uncertainty elasticity of liquidity (UEL: percent change in liquidity given a 1% change in VIX) has increased significantly around regulatory changes in the US markets that increased the role of public traders in liquidity provision, reduced the minimum allowable price variation, weakened the affirmative obligation of NASDAQ dealers, and abolished the specialist system on the NYSE.

Market volatility and liquidity commonality

We conjecture that an important source of liquidity commonality is overall market uncertainty using the Chicago Board Options Exchange Market Volatility Index. This index, often referred to as the fear index or the fear gauge, is a measure of the implied volatility of Standard & Poor's (S&P) 500 index options. Indeed, we find that uncertainty plays an important role in liquidity commonality after controlling for aggregate market liquidity, industry-wide liquidity, and well known determinants of individual stock liquidity, such as return volatility, trading volume, and price.

For NASDAQ stocks, we find that a 1% increase in VIX leads to a 0.46%, 0.49%, and 0.43% increase in the quoted spread, effective spread, and price impact, respectively, and a 0.41% and 0.49% decrease in the quoted depth and market quality index, respectively. We find similar results for NYSE stocks. We also show that the effect of VIX on stock liquidity is greater than the combined effects of all other common determinants of stock liquidity. Apparently, liquidity providers react strongly to general market uncertainty (in addition to individual asset risk), and this behavior generates a commonality in liquidity.

Our results support the view that market liquidity decreases with VIX because higher volatility tightens funding constraints on market makers and thereby reduces their liquidity-provision capacity. Liquidity could disappear during periods of financial market turmoil because liquidity providers demand a higher expected return from liquidity provision during such times. Our results are also consistent with anecdotal evidence that liquidity providers adjust their positions uniformly across stocks according to market volatility as reflected in VIX before they make adjustments based on individual asset risks.

Stock attributes and the uncertainty elasticity of liquidity

Our paper shows that UEL is positively and significantly related to share price, trading volume, and return volatility and negatively and significantly related to firm size (market value of equity) when liquidity is measured by the quoted spread, effective spread, or price impact. When liquidity is measured by the dollar depth or market quality index, the signs of the estimated coefficients on share price, trading volume, firm size, and return volatility are the opposite of those when liquidity is measured by the spreads and price impact: UEL is positively and significantly related to firm size and negatively and significantly related to share price, trading volume, and return volatility. These results suggest that uncertainty exerts a greater impact on the liquidity of stocks with higher price, larger trading volume, greater return volatility, or smaller market capitalizations. The larger UEL of higher priced stocks could arise because the tick size is less likely to be a binding constraint on price quote changes. The larger UEL of high-volume or high-volatility stocks could be due to the fact that these stocks are more likely to exhibit information-based trading, prompting greater reactions from liquidity providers. Uncertainty may exert a smaller impact on the liquidity of larger companies because these companies have lower information-based trading as more information is available about them and, thus, liquidity providers in these stocks may be less sensitive to changes in market volatility. Uncertainty exerts a smaller impact on the liquidity of stocks with higher analyst following or institutional ownership, or both. This could be because liquidity providers in these stocks are less sensitive to changes in market volatility because more information is available through analysts' information collection and dissemination as well as institutional monitoring. We find that uncertainty exerts a larger impact on the liquidity of firms with higher market-to-book ratios. Such firms may have larger intangible assets (e.g., higher proportions of these firms' market values are accounted for by future growth options) and changes in market volatility lead to larger swings in liquidity when firm value is highly subject to future managerial actions.

Risk premium structure and the uncertainty elasticity of liquidity

We conjecture that uncertainty exerts a larger impact on liquidity when public traders play a greater role in liquidity provision, when the minimum price variation (i.e., tick size) is smaller, and when market makers play a smaller role in liquidity provision. We test these conjectures using the following four regulatory changes, which serve as natural experiments, in market structure: (1) the implementation of the new order handling rules (OHR) on NASDAQ in 1997, (2) the reduction of tick size from $1/8 to $1/16 in 1997 and from $1/16 to $0.01 (decimalization) in 2001, (3) the amendment of NASDAQ Rule 4613(c) in 2007 that dealer quotes must be reasonably related to the prevailing market, and (4) the implementation of the designated market maker (DMM) system on the NYSE in 2008.

We show that the effects of VIX on liquidity have changed over time across different market structures. Specifically, we show that the uncertainty elasticity of liquidity (UEL) has increased dramatically around regulatory changes in the US markets that increased the role of public traders in liquidity provision, reduced the minimum allowable price variation, weakened the affirmative obligation of NASDAQ dealers, and abolished the specialist system on the NYSE. These results support the idea that a direct reflection of expected volatility in prices and quotes, without the filtering by market intermediaries, could increase the volatility of market liquidity. Although some of these regulatory changes have been shown to increase pricing efficiency and reduce trading costs, they might also have the unintended consequence of increasing liquidity volatility, leading to an increase in liquidity risk premiums in asset returns.

Conclusion

Prior research shows that the return premium is related to commonality in liquidity with market liquidity, return sensitivity to market liquidity, and liquidity sensitivity to market returns. To the extent that the market volatility-induced liquidity risk cannot be diversified away, such systematic liquidity risk would also be built into the required return of investors. It would be interesting to find out whether stocks with greater UELs command higher return premiums after controlling for other liquidity-related risk factors shown in prior research. Our results show that the uncertainty elasticity of liquidity is greater than the liquidity commonality with the market liquidity, suggesting that the risk premium associated with the former could be even greater than the risk premium associated with the latter.


constantinides-y
.