A market is liquid if transactions take place rapidly and individual transactions have little impact on prices. So defined, market liquidity, which is different from monetary or aggregate liquidity familiar to central bankers and macro-economists, has several dimensions: immediacy, depth, tightness and resiliency. Immediacy refers to the speed with which a trade of a given size at a given cost is completed. Depth refers to the maximal size of a trade for any given bid-ask spread. Tightness refers to the difference between buy and sell prices, for example, the bid-ask spread in a quote-driven market. Resiliency refers to how quickly prices revert to original or fundamental levels after a large transaction. In the context of the government securities markets, which are typically multiple dealer over-the-counter markets, liquidity is better thought of in terms of cost of supplying immediacy.
At a fundamental level, market liquidity is determined by the degree of heterogeneity in expectations and portfolio decisions of the market makers. When there is heterogeneity in the portfolio decisions, there is scope for arbitrage and trade. When there is lack of heterogeneity, in the sense of every one using similar trading strategy, the market becomes relatively one-sided and the costs of finding a counter party will be very high. Market heterogeneity, in turn, depends on the nature of objectives and the expectations of market makers.
In G-sec markets, where the scope for private information about the fundamental value of the security is low -- all participants are expected to have equal access to the macroeconomic information affecting risk-free interest rates -- optimal inventory management would constitute the primary objective for market makers. In contrast to equity markets, the costs of inventory management, rather than the costs of asymmetric information, therefore, would determine the costs of supplying immediacy and hence liquidity.
The process of expectation formation in G-sec markets is driven by the policy environment and market infrastructure. Macroeconomic policies with their implications for general growth prospects of the economy, and specific policies of the central bank related to debt markets and interest rates, will drive the interest rate expectations of the market participants. Expectations about the macro fundamentals would typically be varied across market participants, except in terms of severe crisis. Policies of central banks, on the other hand, aimed at guiding the markets to attain certain intermediate targets (such as lower interest rates) might end up creating a momentum factor in the markets, because of which market participants would act in a similar manner in response to any shock.
For example, consider the general belief about a low interest scenario based on the insistence on a softer interest rate regime by the government and the Reserve Bank. The decline in secondary market yields of both, short and long yields on government securities is an indication that market participants are trading under the assumption that the central bank will keep the interest rates down since letting them increase will lead to significant increases in the costs of servicing public debt, a situation that the government cant afford, particularly in a recessionary environment.
Despite the fact that the fundamentals, such as high fiscal deficits, do not support lower longer-term interest rates, markets seem to believe in the ability of the RBI to keep down the entire term structure and not just the short rates. This is a dangerous situation since markets are betting on RBIs policies and thereby increasing the possibility of responding to any policy shock in a homogenous manner. This, coupled with the common objective of optimal inventory management by market participants, can lead to common trading strategies and in the process make market liquidity vulnerable to policy changes.
(This article is the second in a three-part series. The author is a consultant with the National Stock Exchange. Views expressed are personal. E-mail: email@example.com)