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An Insight into Market Liquidity

Douglas Elliott, a fellow at the Brookings Institution, offers a view into the current state of market liquidity in a recent piece. Elliott defines market liquidity as “the ability of buyers and sellers of securities to transact efficiently and is measured by the speed with which large purchases and sales can be executed and the transaction costs incurred in doing so.” Looking at a variety of liquidity measures, Elliott finds the evidence ambiguous, but predicts that it is “highly likely” that market liquidity will only worsen due to “the evolution of the structure of financial markets and the effects of unusual economic conditions, especially extremely loose monetary policies and massive direct central bank purchases of bonds” as well as imposing regulation that resulted in “producing more social costs than the benefits of greater financial stability.” However, Elliott sees several factors acting to partially offset these effects, including increased activity by smaller dealers and hedge funds (which are not subject to the same regulatory constraints as the large dealers), the continuing growth of electronic markets, and potential greater standardization of offerings by issuers.

Elliott argues that regulators should undertake an “integrated review” to assess the combined effects of regulatory initiatives that may have “overshot.” He noted that “[i]deally, the Financial Stability Oversight Council would coordinate such trade-offs, but in practice, its focus has been to look for financial stability risks, rather than to determine when some regulators may have unintentionally overshot by creating costs to society that fall outside their own direct responsibility.” He recommends a strong cost-benefit analysis and believes that “the level of conservatism in certain new regulations could be trimmed back modestly and selectively to reduce the harm to market liquidity without sacrificing any significant improvement to systemic safety.”