Ebook Market microstructure and market liquidity

In this paper we review the factors which affect market liquidity and present a framework which measures such effects quantitatively. This framework enables us to clarify the logic behind recent market reforms and the introduction of rules (e.g. the introduction of electronic trading, the development of disclosure of trade information for market participants, and the prevalence of computerised bilateral transactions). Market liquidity has long been implicitly assumed to exist when market participants evaluate the prices of financial products and manage their portfolios and when central banks implement monetary policy. Since the cost of losing market liquidity is large despite its implicit nature, the improvement and stability of market liquidity is not only important for market participants, but also serves as a way to enhance financial market stability.

This paper is composed of two major parts: a survey of the concepts relating to the factors which affect market liquidity and verification by simulation. In the conceptual summary part, we first summarise the definition of market liquidity and the relationship between market liquidity and market efficiency or stability. Based on the summary, we consider the price discovery mechanism, in which potential trade needs are actually realised in the market as order flows and prices are discovered by matching such orders, and we clarify our direction toward simulation model construction. In the simulation, we assume a certain market structure and focus on the parameters which affect an individual market participant’s ordering decision, such as expectation of the asset price, confidence in such expectation, the extent of risk aversion, sensitivity to various kinds of market information. These parameters determine the realisation process of potential trade needs of market participants according to the market structure.

Therefore, through the simulation we observe, as a mechanism in which market structure affects the state of market liquidity, how the above parameters affect market behaviour. Recently, simulation techniques have been widely used in the area of economics, and are useful in analysing an economic mechanism, which is an aggregate of complex individual behaviours. In our analysis, we do not deal with actual markets which trade specific goods such as foreign exchange, stocks, or government bonds, but assume a market in which hypothetical assets or securities are traded. Although some studies have dealt with the foreign exchange market or analyses of government bond markets, many studies have focused mainly on the New York Stock Exchange. In our analysis, instead of recognising the difference between markets by the character of the goods traded, we regard the difference as a difference of market microstructure or trading rules, and try to capture their general effects on market liquidity.