What is Liquidity? (Part III)

I have had a number of posts on liquidity over the past few years, in an attempt to explain an ill-understood phenomenon.  Here is a sampling:

Because of high frequency trading, I want to take another stab at what liquidity is.  Limit orders offer liquidity; an investor or market maker offers to buy or sell at a fixed price.  Market orders consume liquidity — they lift or hit limit orders, often forcing the bid-ask spread wider.

But not all limit orders are the same.  They vary because:

  • Some limit orders narrow the bid-ask spread, which aids liquidity.
  • Some limit orders bid/offer more shares, which increases liquidity.
  • Some limit orders hang out there for a long time, which also boosts liquidity.

Liquidity means being able to make a choice, and if possible to do it in size, at a price that you like.  Also, for many of us, it means that we have some amount of time to think about the price.  That is liquidity — the ability to buy or sell in size without having to “bust a gut” to do so.

High frequency traders claim to add liquidity, but their bids and asks are ephemeral.  They add little liquidity, because the average investor can’t act on them.  They are like market orders, because they are gone in a flash, consuming longer-dated liquidity.

I am not saying that high frequency trading should be illegal, but that investors and market makers should carefully consider the rules where they trade.  For investors: are you trading in a market where you have a disadvantage?  For market makers: you should be the heavy hitter here; don’t let anyone more powerful/fast in.  Operate your market for the best interests of all, and ignore those that want an advantage.  In some cases this may mean executing trades once every five seconds, or any such similar interval.

Level playing fields promote broad markets.  Let clever market makers so structure their businesses, that level playing fields dominate investing.