Showing papers on "Liquidity risk published in 2008"
TL;DR: The authors summarizes and explains the main events of the liquidity and credit crunch in 2007-08, starting with the trends leading up to the crisis and explaining how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.
Abstract: This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.
3,033 citations
TL;DR: In this article, the impact of cross-bank liquidity variation induced by unanticipated nuclear tests in Pakistan was examined by exploiting crossbank liquidity variations induced by the nuclear tests, and it was shown that for the same firm borrowing from two different banks, its loan from the bank experiencing a 1 percent larger decline in liquidity drops by an additional 0.6 percent.
Abstract: We examine the impact of liquidity shocks by exploiting cross-bank liquidity variation induced by unanticipated nuclear tests in Pakistan. We show that for the same firm borrowing from two different banks, its loan from the bank experiencing a 1 percent larger decline in liquidity drops by an additional 0.6 percent. While banks pass their liquidity shocks on to firms, large firms-particularly those with strong business or political ties-completely compensate this loss by additional borrowing through the credit market. Small firms are unable to do so and face large drops in overall borrowing and increased financial distress.
1,444 citations
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TL;DR: This article showed that carry traders are subject to crash risk, i.e. exchange rate movements between high-interest-rate and low-interest rate currencies are negatively skewed, due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease.
Abstract: This paper documents that carry traders are subject to crash risk: i.e. exchange rate movements between high-interest-rate and low-interest-rate currencies are negatively skewed. We argue that this negative skewness is due to sudden unwinding of carry trades, which tend to occur in periods in which risk appetite and funding liquidity decrease. Funding liquidity measures predict exchange rate movements, and controlling for liquidity helps explain the uncovered interest-rate puzzle. Carry-trade losses reduce future crash risk, but increase the price of crash risk. We also document excess co-movement among currencies with similar interest rate. Our findings are consistent with a model in which carry traders are subject to funding liquidity constraints.
941 citations
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TL;DR: In this paper, the authors investigated the relation between stock liquidity and firm performance and found that firms with liquid stocks have better performance as measured by the firm market-to-book ratio.
Abstract: This paper investigates the relation between stock liquidity and firm performance. The study documents that firms with liquid stocks have better performance as measured by the firm market-to-book ratio. This result is robust to the inclusion of industry or firm fixed effects, a control for idiosyncratic risk, a control for endogenous liquidity using two stage least squares, and the use of alternative measures of liquidity. To identify the causal effect of liquidity on firm performance, we study an exogenous shock to liquidity --- the decimalization of stock trading --- and document that the increase in liquidity around decimalization improves firm performance. The causes of liquidity’s beneficial effect are investigated: Liquidity increases the information content of market prices and of performance sensitive managerial compensation. Finally, momentum trading, analyst coverage, investor overreaction, and the effect of liquidity on discount rates or expected returns do not appear to drive the results.
480 citations
TL;DR: In this paper, the authors estimate latent factor models of liquidity, aggregated across various liquidity measures, and find that across-measure systematic liquidity is a priced factor while within measure systematic liquidity does not exhibit additional pricing information.
425 citations
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TL;DR: In this article, the empirical relation between corporate governance and stock market liquidity was investigated and it was shown that firms with better corporate governance have narrower spreads, higher market quality index, smaller price impact of trades, and lower probability of information-based trading.
Abstract: We investigate the empirical relation between corporate governance and stock market liquidity. We find that firms with better corporate governance have narrower spreads, higher market quality index, smaller price impact of trades, and lower probability of information-based trading. In addition, we show that changes in our liquidity measures are significantly related to changes in the governance index over time. These results suggest that firms may alleviate information-based trading and improve stock market liquidity by adopting corporate governance standards that mitigate informational asymmetries. Our results are remarkably robust to alternative model specifications, across exchanges, and different measures of liquidity.
404 citations
TL;DR: In this paper, the authors investigate how systemic risk is affected by the structure of the financial system and find that the better capitalised banks are, the more resilient is the banking system against contagious defaults and this effect is nonlinear.
Abstract: Systemic risk is a key concern for central banks charged with safeguarding overall financial stability. In this paper we investigate how systemic risk is affected by the structure of the financial system. We construct banking systems that are composed of a number of banks that are connected by interbank linkages. We then vary the key parameters that define the structure of the financial system - including its level of capitalisation, the degree to which banks are connected, the size of interbank exposures and the degree of concentration of the system - and analyse the influence of these parameters on the likelihood of contagious (knock-on) defaults. First, we find that the better capitalised banks are, the more resilient is the banking system against contagious defaults and this effect is non-linear. Second, the effect of the degree of connectivity is non-monotonic, that is, initially a small increase in connectivity increases the contagion effect; but after a certain threshold value, connectivity improves the ability of a banking system to absorb shocks. Third, the size of interbank liabilities tends to increase the risk of knock-on default, even if banks hold capital against such exposures. Fourth, more concentrated banking systems are shown to be prone to larger systemic risk, all else equal. In an extension to the main analysis we study how liquidity effects interact with banking structure to produce a greater chance of systemic breakdown. We finally consider how the risk of contagion might depend on the degree of asymmetry (tiering) inherent in the structure of the banking system. A number of our results have important implications for public policy, which this paper also draws out.
381 citations
TL;DR: In this paper, the authors present an empirical study of the pricing effect of liquidity in the credit default swaps (CDS) market and construct liquidity proxies to capture various facets of CDS liquidity including adverse selection, search frictions, and inventory costs.
Abstract: We present an empirical study of the pricing effect of liquidity in the credit default swaps (CDS) market. We construct liquidity proxies to capture various facets of CDS liquidity including adverse selection, search frictions, and inventory costs. We show that the liquidity effect on CDS spreads is significant with an estimated liquidity premium on par with those of Treasury bonds and corporate bonds. Our finding of cross-sectional variations in the liquidity effect highlights the structure of the search-based over-the-counter market and the interplay between search friction and adverse selection in CDS trading. Using liquidity betas and volume respectively to measure liquidity risk, we find supporting evidence for liquidity risk being priced beyond liquidity level in the CDS market.
261 citations
TL;DR: In this article, the authors explore the determinants of yield differentials between sovereign bonds, using Euro area data, and find that there is a common trend in yield differential, which is correlated with a measure of aggregate risk.
Abstract: The paper explores the determinants of yield differentials between sovereign bonds, using Euro area data. There is a common trend in yield differentials, which is correlated with a measure of aggregate risk. In contrast, liquidity differentials display sizeable heterogeneity and no common factor. We propose a simple model with endogenous liquidity demand, where a bond's liquidity premium depends both on its transaction cost and on investment opportunities. The model predicts that yield differentials should increase in both liquidity and risk, with an interaction term of the opposite sign. Testing these predictions on daily data, we find that the aggregate risk factor is consistently priced, liquidity differentials are priced for a subset of countries, and their interaction with the risk factor is in line with the model's prediction and crucial to detect their effect.
192 citations
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TL;DR: In this article, the authors argue that the growth rate of aggregate balance sheets may be the most fitting measure of liquidity in a market-based financial system, and they show a strong correlation between balance sheet growth and the easing and tightening of monetary policy.
Abstract: A close look at how financial intermediaries manage their balance sheets suggests that these institutions raise their leverage during asset price booms and lower it during downturns - pro-cyclical actions that tend to exaggerate the fluctuations of the financial cycle. The authors of this study argue that the growth rate of aggregate balance sheets may be the most fitting measure of liquidity in a market-based financial system. Moreover, the authors show a strong correlation between balance sheet growth and the easing and tightening of monetary policy.
191 citations
TL;DR: In this article, the authors explore the pricing of debt in a financial system where the assets that borrowers hold to meet their obligations include claims against other borrowers, and assess financial claims in a system context.
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TL;DR: In this paper, the authors identify the drivers of the increase in risk premium contained in the interest rates on three-month interbank deposits at large, internationally active banks and identify the role of credit and liquidity factors.
Abstract: The risk premium contained in the interest rates on three-month interbank deposits at large, internationally active banks increased sharply in August 2007 and risk premiahave remained at an elevated level since. This feature aims to identify the drivers of this increase, in particular the role of credit and liquidity factors. While there is evidence of a role played by credit risk, at least at lower frequencies, the absence of a close relationship between the risk of default and risk premia in the money market, as well as the reaction of the interbank markets to central bank liquidity provisions, point to the importance of liquidity factors for banks’ day-to-day quoting behaviour.
TL;DR: In this article, the authors introduce new liquidity measures, effective spread, realized spread, and price impact based on both TAQ and Rule 605 data, including the decimals era, and run horseraces of both monthly and annual liquidity measures.
Abstract: Liquidity plays an increasingly important role in empirical asset pricing, market efficiency, and corporate finance. Identifying high quality proxies for liquidity based on daily data only (not intraday data) would permit liquidity to be studied over relatively long timeframes and across many countries. We introduce new liquidity measures. We run horseraces of both monthly and annual liquidity measures. Our benchmarks are effective spread, realized spread, and price impact based on both TAQ and Rule 605 data, including the decimals era. We identify the best proxies in each case and find that the new liquidity measures win the majority of horseraces
TL;DR: In this paper, the authors focus on various modes of Islamic finance and examine their risk and other characteristics by conducting a selective literature review, they theoretically examined and various performance indicators of two Islamic banks are also examined to compare them with traditional banks that practice mark up pricing.
Abstract: Purpose – The purpose of this paper is to focus on various modes of Islamic finance and examines their risk and other characteristics by conducting a selective literature review.Design/methodology/approach – Due to the Islamic prohibition of interest and in compliance with injunctions on permissible trade contracts, the savings and investment contracts offered by Islamic banks have a different risk profile than those of conventional banks. This gives rise to a number of regulatory issues pertaining to capital adequacy and liquidity requirements. Operational issues also arise as Islamic banks are limited in their choice of risk and liquidity management tools such as derivatives, options and bonds. All these issues are theoretically examined and various performance indicators of two Islamic banks are also examined to compare them with traditional banks that practice mark up pricing.Findings – The balance sheets and various performance indicators show that there is evidence that Islamic banks in Pakistan ten...
TL;DR: This article studied whether stock returns' sensitivities to aggregate liquidity fluctuations and the pricing of liquidity risk vary over time and found that liquidity betas vary across two distinct states: one with high liquidity beta and the other with low beta.
Abstract: This paper studies whether stock returns' sensitivities to aggregate liquidity fluctuations and the pricing of liquidity risk vary over time. We find that liquidity betas vary across two distinct states: one with high liquidity betas and the other with low betas. The high liquidity-beta state is short lived and characterized by heavy trade, high volatility, and a wide cross-sectional dispersion in liquidity betas. It also delivers a disproportionately large liquidity risk premium, amounting to more than twice the value premium. Our results are consistent with a model of liquidity risk in which investors face uncertainty about their trading counterparties' preferences.
Journal Article•
TL;DR: In this paper, a multivariate integer count hurdle model is proposed for high frequency financial econometrics and the mixture of distribution hypothesis is used to model exchange rate volatility and order aggressiveness and order book dynamics.
Abstract: Editor's introduction: Recent developments in high frequency financial econometrics.- Exchange rate volatility and the mixture of distribution hypothesis.- A multivariate integer count hurdle model: Theory and application to exchange rate dynamics.- Asymmetries in bid and ask responses to innovation in the trading process.- Liquidity supply and adverse selection in a pure limit oder book market.- How large is liquidity risk in an automated auction market.- Order aggressiveness and order book dynamics.- Modelling financial transaction price movements: a dynamic integer count data model.- The performance analysis of chart patterns: Monte Carlo simulation and evidence from the euro/dollar foreign exchange market.- Semiparametric estimation for financial durations.- Intraday stock prices, volume, and duration: a nonparametric conditional density approach.- Macroeconomic surprises and short-term behaviour in bond futures.- Dynamic modelling of large dimensional covariance matrices.
Book•
01 Jan 2008
TL;DR: In this article, the authors present a framework for measuring risk in financial institutions using a return on equity (ROE) framework, based on the Black-Scholes option pricing model.
Abstract: Part I Introduction Ch. 1 Why Are Financial Institutions Special? Appendix 1A The Financial Crisis: The Failure of Financial Services Institution Specialness (online) Appendix 1B Monetary Policy Tools (online) Ch. 2 Financial Services: Depository Institutions Appendix 2A Financial Statement Analysis Using a Return on Equity (ROE) Framework (online) Appendix 2B Commercial Banks' Financial Statements and Analysis (online) Appendix 2C Depository Institutions and Their Regulators (online) Appendix 2D Technology in Commercial Banking (online) Ch. 3 Financial Services: Finance Companies Ch. 4 Financial Services: Securities Brokerage and Investment Banking Ch. 5 Financial Services: Mutual Funds and Hedge Funds Ch. 6 Financial Services: Insurance Ch. 7 Risks of Financial Institutions Part II Measuring Risk Ch. 8 Interest Rate Risk I Appendix 8A The Maturity Model (online) Appendix 8B Term Structure of Interest Rates Ch. 9 Interest Rate Risk II Appendix 9A The Basics of Bond Valuation (online) Appendix 9B Incorporating Convexity into the Duration Model Ch. 10 Credit Risk: Individual Loan Risk Appendix 10A Credit Analysis (online) Appendix 10B Black-Scholes Option Pricing Model (online) Ch. 11 Credit Risk: Loan Portfolio and Concentration Risk Appendix 11A CreditMetrics Appendix 11B CreditRisk+ Ch. 12 Liquidity Risk Appendix 12A Sources and Uses of Funds Statement, Bank of America, March 2012 (online) Ch. 13 Foreign Exchange Risk Ch. 14 Sovereign Risk Appendix 14A Mechanisms for Dealing with Sovereign Risk Exposure Ch. 15 Market Risk Ch. 16 Off-Balance-Sheet Risk Appendix 16A A Letter of Credit Transaction (online) Ch. 17 Technology and Other Operational Risks Part III Managing Risk Ch. 18 Liability and Liquidity Management Appendix 18A Federal Reserve Requirement Accounting (online) Appendix 18B Bankers Acceptances and Commercial Paper as Sources of Financing (online) Ch. 19 Deposit Insurance and Other Liability Guarantees Appendix 19A Calculation of Deposit Insurance Premiums Appendix 19B FDIC Press Releases of Bank Failures (online) Appendix 19C Deposit Insurance Coverage for Commercial Banks in Various Countries (online) Ch. 20 Capital Adequacy Appendix 20A Internal Ratings-Based Approach to Measuring Credit Risk-Adjusted Assets Appendix 20B Methodology Used to Determine G-SIBs Capital Surcharge (online) Ch. 21 Product and Geographic Expansion Appendix 21A EU and G-10 Countries: Regulatory Treatment of the Mixing of Banking, Securities, and Insurance Activities and the Mixing of Banking and Commerce (online) Ch. 22 Futures and Forwards Appendix 22A Microhedging with Futures (online) Ch. 23 Options, Caps, Floors, and Collars Appendix 23A Black-Scholes Option Pricing Model (online) Appendix 23B Microhedging with Options (online) Ch. 24 Swaps Appendix 24A Setting Rates on an Interest Rate Swap Ch. 25 Loan Sales Ch. 26 Securitization Appendix 26A Fannie Mae and Freddie Mac Balance Sheets (online)
TL;DR: The authors compare the performance of the banks and bonds model and the traditional neo-Wicksellian model in terms of second moments, variance decompositions and impulse response functions, and study the role of monetary aggregates and velocity in predicting inflation in the two models.
Abstract: Woodford (2003) describes a popular class of neo-Wicksellian models in which monetary policy is characterized by an interest-rate rule, and the money market and financial institutions are typically not even modelled. Critics contend that these models are incomplete and unsuitable for monetary-policy evaluation. Our Banks and Bonds model starts with a standard neo-Wicksellian model and then adds banks and a role for bonds in the liquidity management of households and banks. The Banks and Bonds model gives a more complete description of the economy, but the neo-Wicksellian model has the virtue of simplicity. Our purpose here is to see if the neo-Wicksellian model gives a reasonably accurate account of macroeconomic behaviour in the more complete Banks and Bonds model. We do this by comparing the models' second moments, variance decompositions and impulse response functions. We also study the role of monetary aggregates and velocity in predicting inflation in the two models.
TL;DR: In this article, a new liquidity measure quantifying the price dispersion in the context of the US corporate bond market is proposed, and the authors show that the price deviations are significantly larger and more volatile than previously assumed.
Abstract: In this paper, we model price dispersion effects in over-the-counter (OTC) markets to show that in the presence of inventory risk for dealers and search costs for investors, traded prices may deviate from the expected market valuation of an asset. We interpret this deviation as a liquidity effect and develop a new liquidity measure quantifying the price dispersion in the context of the US corporate bond market. This market offers a unique opportunity to study liquidity effects since, from October 2004 onwards, all OTC transactions in this market have to be reported to a common database known as the Trade Reporting and Compliance Engine (TRACE). Furthermore, market-wide average price quotes are available from Markit Group Limited, a financial information provider. Thus, it is possible, for the first time, to directly observe deviations between transaction prices and the expected market valuation of securities. We quantify and analyze our new liquidity measure for this market and find significant price dispersion effects that cannot be simply captured by bid-ask spreads. We show that our new measure is indeed related to liquidity by regressing it on commonly-used liquidity proxies and find a strong relation between our proposed liquidity measure and bond characteristics, as well as trading activity variables. Furthermore, we evaluate the reliability of end-of-day marks that traders use to value their positions. Our evidence suggests that the price deviations are significantly larger and more volatile than previously assumed. Overall, the results presented here improve our understanding of the drivers of liquidity and are important for many applications in OTC markets, in general.
TL;DR: In this article, a simple frictionless model was proposed for the U.S. government bond and stock markets, which showed that volume and liquidity are unrelated in the model but volume is positively related to the variance of liquidity, or liquidity risk.
01 Jan 2008
TL;DR: In this article, the authors consider a model of liquidity demand arising from maturity mismatch on one side of the market and show that an immediate-trading equilibrium always exists, where liquidity trading occurs in anticipation of a liquidity shock.
Abstract: We consider a model of liquidity demand arising from maturity mismatch on one side of the market. This demand can be met with either the cash held by those with the liquidity need, what we refer to as inside liquidity, or alternatively via asset sales. In this latter case then assets are exchanged for the cash held by agents other than those with these liquidity needs. We refer to this cash as outside liquidity. The questions we address are: (a) what determines the mix of inside and outside liquidity in equilibrium? (b) does the market provide an e‐cient mix of inside versus inside liquidity? and (c) if not, what kind of interventions can be proposed to restore e‐ciency? We argue that a key determinant of the aforementioned mix is the timing of the liquidation decision. An important source of ine‐ciency is the presence of asymmetric information about asset values, which increases the longer a liquidity trade is delayed. We establish that an immediate-trading equilibrium always exists, where liquidity trading occurs in anticipation of a liquidity shock. Another, delayed-trading equilibrium, in which liquidity trading is a response to a liquidity shock, may also exist. We show that, when it exists, the delayed-trading equilibrium is e‐cient, despite the presence of adverse selection. ⁄ Preliminary and incomplete. Please do not quote without permission. We thank Rafael Repullo and Lasse Pedersen as well as participants at workshops and seminars at Columbia University, Toulouse School of Economics and the 2008 NBER Summer Institute on Risks of Financial Institutions for their comments and suggestions.
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TL;DR: In a modern market-based financial system, the channel of contagion is through price changes and the measured risks and marked-to-market capital of financial institutions when balance sheets are marked to market, asset price changes show up immediately on balance sheets and elicit response from financial market participants.
Abstract: There is an apparent puzzle at the heart of the 2007 credit crisis The subprime mortgage sector is small relative to the financial system as a whole and the exposure was widely dispersed through securitization Yet the crisis in the credit market has been potent Traditionally, financial contagion has been viewed through the lens of defaults, where if A has borrowed from B and B has borrowed from C, then the default of A impacts B, which then impacts C, etc However, in a modern market-based financial system, the channel of contagion is through price changes and the measured risks and marked-to-market capital of financial institutions When balance sheets are marked to market, asset price changes show up immediately on balance sheets and elicit response from financial market participants Even if exposures are dispersed widely throughout the financial system, the potential impact of a shock can be amplified many-fold through market price changes
TL;DR: In this article, the authors use insights from the academic literature on crises to understand the role of liquidity in the current crisis and focus on four crucial features of the crisis that they argue are related to liquidity provision.
Abstract: The purpose of this paper is to use insights from the academic literature on crises to understand the role of liquidity in the current crisis. We focus on four of the crucial features of the crisis that we argue are related to liquidity provision. The first is the fall of the prices of AAA-rated tranches of securitized products below fundamental values. The second is the effect of the crisis on the interbank markets for term funding and on collateralized money markets. The third is fear of contagion should a major institution fail. Finally, we consider the effects on the real economy.
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TL;DR: In this paper, the authors examine the linkages between market and funding liquidity pressures, as well as their interaction with solvency issues surrounding key financial institutions during the 2007 subprime crisis.
Abstract: We examine the linkages between market and funding liquidity pressures, as well as their interaction with solvency issues surrounding key financial institutions during the 2007 subprime crisis. A multivariate GARCH model is estimated in order to test for the transmission of liquidity shocks across U.S. financial markets. It is found that the interaction between market and funding illiquidity increases sharply during the recent period of financial turbulence, and that bank solvency becomes important.
TL;DR: In this paper, the authors show that marked-to-market leverage is strongly procyclical and that changes in aggregate balance sheets for intermediaries forecast changes in risk appetite in financial markets, as measured by the innovations in the VIX index.
Abstract: In a …nancial system where balance sheets are continuously marked to market, asset price changes show up immediately in changes in net worth, and elicit responses from …nancial intermediaries who adjust the size of their balance sheets. We document evidence that marked-to-market leverage is strongly procyclical. Such behavior has aggregate consequences. Changes in aggregate balance sheets for intermediaries forecast changes in risk appetite in …nancial markets, as measured by the innovations in the VIX index. Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the …nancial intermediaries.
Patent•
16 Jan 2008
TL;DR: A method, system and computer program that receives, processes, and displays level one, level two, and time and sales securities data through a variety of charts, the data is analyzed to identify liquidity trade imbalances and trends in trading liquidity as mentioned in this paper.
Abstract: A method, system and computer program that receives, processes, and displays level one, level two, and time and sales securities data Through a variety of charts, the data is analyzed to identify liquidity trade imbalances and trends in trading liquidity A logic based trading algorithm utilizes the current market maker activity information and the historical liquidity tiers to execute trades automatically
TL;DR: In this article, the authors investigate how the dynamic effects of excess liquidity shocks on economic activity, asset prices and inflation differ over time and show that the impact varies considerably over time, depending on the source of increased liquidity (M1, M3-M1 or credit) and the underlying state of the economy.
Abstract: In this paper, we investigate how the dynamic effects of excess liquidity shocks on economic activity, asset prices and inflation differ over time. We show that the impact varies considerably over time, depends on the source of increased liquidity (M1, M3-M1 or credit) and the underlying state of the economy (asset price boom-bust, business cycle, inflation cycle, credit cycle and monetary policy stance).
TL;DR: In this paper, the authors build a model that helps to explain why increases in liquidity -such as lower bid-ask spreads, a lower price impact of trade, or higher turnover - predict lower subsequent returns in both firm-level and aggregate data.
Abstract: We build a model that helps to explain why increases in liquidity - such as lower bid-ask spreads, a lower price impact of trade, or higher turnover - predict lower subsequent returns in both firm-level and aggregate data. The model features a class of irrational investors, who underreact to the information contained in order flow, thereby boosting liquidity. In the presence of short-sales constraints, high liquidity is a symptom of the fact that the market is dominated by these irrational investors, and hence is overvalued. This theory can also explain how managers might successfully time the market for seasoned equity offerings, by simply following a rule of thumb that involves issuing when the SEO market is particularly liquid. Empirically, we find that: i) aggregate measures of equity issuance and share turnover are highly correlated; yet ii) in a multiple regression, both have incremental predictive power for future equal-weighted market returns.
TL;DR: In this paper, the authors examine the impact of block ownership on the firm's trading activity and secondary-market liquidity and find that block ownership takes potential trading activity off the table relative to a diffuse ownership structure and impairs the market liquidity.
Abstract: We examine the impact of block ownership on the firm's trading activity and secondary-market liquidity. Our empirical results show that block ownership takes potential trading activity off the table relative to a diffuse ownership structure and impairs the firm's market liquidity. These adverse liquidity effects disappear, however, once we control for trading activity. Our findings suggest that block ownership is detrimental to the firm's market liquidity because of its adverse impact on trading activity - a real friction effect. After controlling for this real friction effect, we find little evidence that block ownership has a negative impact on informational friction. Our results suggest that the relative lack of trading, and not the threat of informed trading, explains the inverse relation between block ownership and market liquidity.
TL;DR: In this article, the impact of pre-trade transparency on liquidity in a market where risk-averse traders accommodate the liquidity demand of noise traders was studied, and it was shown that disclosure of traders' identities improves liquidity by mitigating adverse selection.
Abstract: The tendency to introduce anonymity into financial markets apparently runs counter to the theory supporting transparency. This paper studies the impact of pre-trade transparency on liquidity in a market where risk-averse traders accommodate the liquidity demand of noise traders. When some risk-averse investors become informed, an adverse selection problem ensues for the others, making them reluctant to supply liquidity. Hence the disclosure of traders' identities improves liquidity by mitigating adverse selection. However, informed investors are effective liquidity suppliers, as their adverse selection and inventory costs are minimized. With endogenous information acquisition, transparency reduces the number of informed investors, thus decreasing liquidity. The type of information that traders hold and the effectiveness of insider trading regulation are crucial to distinguish between equilibria. Copyright 2008, Oxford University Press.