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Börse Frankfurt

Liquidity: See-Sawing Prices Can Hurt Bottom Line

How Liquidity Can Influence Yields


Anyone can see it on his or her securities account statement: the transaction costs – bank fees, commissions and taxes that arise from order preparation and transaction clearing – are listed clearly. Indirect transaction costs that arise from a lack of liquidity, however, disappear in the fog. Statements such as, “Don’t touch it, that share’s liquidity is far too low,” are often used to warn investors before they make a move. But was does that really mean?

“Dry” markets – Expensive trading


First of all, liquidity describes the availability of a security and expresses itself in terms of the costs that arise from trading this title. Figuratively speaking, liquidity is the lubricant that keeps the market process of price determination well oiled. Remember, share prices are determined by a perception of what the price should be on the part of the buyer and seller. In a perfect market there is sufficient supply and demand. Every order placed for a security will be filled immediately, in such a manner that the individual order does not move the price of the security.

But in reality markets don’t obey this theoretical outline – and the lack of liquidity actually costs investors money. This happens in two ways: first, a buy or sell order in an illiquid market shifts the course to the disfavor of the investor. This is no different than when a car dealer increases the price of a car for a particular customer because he realizes that the car is exactly what the customer wants. Additionally, the competition, as far as the dealer can tell, will not have the same type of car in the near future.

Second, an order placed in an illiquid market is not immediately fulfilled. If someone wants to sell a security for which there is no offer, one option is to wait until he finds a buyer. But the longer the sell order sits on the books, the higher the risk that the price of the security will decline – due to, for example, changing economic or corporate conditions. In this case, the seller can no longer achieve the original price, which had been valid at the time of placing the order. If the investor still wants to sell immediately, he runs the risk of being able to sell only at a much lower price. The reason: the trader who takes the security on his books now bears the risks. Does he have all the information that determines the price of this security? Will he get rid of it on this trading day? Or will he have to hold onto it for longer, thus run the risk of falling prices. He will only take it on his books for a certain price that will cover these risks and costs.

Using the car example: The seller offers his car at listing price, but no-one wants to buy it at the present time. The seller can wait, risking a further decline in value, or he can sell it to a dealer. The dealer will naturally ask for a reduction on the list price; the reduction will be based on his expected chances of selling the car.

This discount is expressed on the stock market in the trading margin. The theoretical fair price (the car’s list price) lies in the middle between the buy and sell offers.

A security’s liquidity, then, is dependent on two factors. The first is the number of shares that are in circulation (the amount of comparable cars of the same model); the second is the number of market participants who are prepared to buy or sell this security (how many people who want to buy cars and the number of dealers in a given region).

In summary, liquidity costs arise from two components: costs from informational risks and costs from holding a security on an order book. These are reflected in the trading margin, which is published in the form of buy and sell prices.

Recognizing illiquid markets


How can the liquidity of a security be determined? The trading margin gives an idea as to the existing liquidity. Beyond that, it can be estimated using simple activity statistics such as trading volume, number of price determinations, etc. But the trading activity does not necessarily reflect the liquidity, because the level of activity on a market place depends on altogether different factors, such as performance expectations.

Example: If an investor had wanted to buy shares in the SDAX-listed TAKKT AG on Xetra at the end of May 2011, the supply and demand certainly would have been in the order book. Still, she would have had to have paid €11.38 per share. Anyone who would have wanted to sell at the same time would have gotten €11.30 per share. The difference between the bid and ask quotes was 0.7 percent, or 8 cents. In a perfect market, where buys and sells can be transacted at all times, the price of the share would correspond to the midpoint of the two prices. The theoretical market value in our example is €11.34. For a round trip (buy and sell the same share) at the same time period, the investor would have paid 0.7 percent of the invested money. In comparison, the same round trip for a share in Deutsche Telekom would have cost the investor only 0.07 percent.

At an investment volume of €10,000, this investor would have been hit with the same direct transaction costs for both shares. However, when buying shares in TAKKT AG, she would have paid a liquidity premium and thus implicit fees of €70; for Telekom, she would have paid only €7. In order to get the same gross yield from this investment, the technology share would have to deliver a corresponding amount.

This simple calculation gives investors an instrument with which to estimate the costs of their securities transactions. The more liquid the market, the lower the costs.

The difference between the actual buying price and the theoretical market value is reflected in the trading costs incurred in markets that are not perfectly liquid. But this difference captures only one dimension of liquidity. It considers only the width of the market. The market’s depth must also be included when assessing hidden transaction costs. That means the prices that must be paid for different transaction volumes. With large orders from institutional investors, demand often exceeds the volume for which prices have been set. The orders, then, are executed against several limits on the corresponding side of the order book, whereby each execution makes the average execution price for the order worse.

A yardstick for liquidity


Measuring the costs that arise from a lack of availability is the job of the Xetra Liquidity Measure, or XLM. It determines the liquidity based on the various bid and ask quotes for various transaction volumes. The XLM has been in play since 2002 for all securities traded on Xetra. The XLM measurement is published in basis points, where 100 points equal 1 percent. The hidden, liquidity-based transaction costs for every trading volume can be determined. The most liquid instrument, the Xetra Top Liquids, can be called up on the Internet each day. They are based on the previous trading day. In May 2011, MAN has been leading the list. At that time, a round trip would have cost the investor 2.5 basis points of the invested amount.

The most liquid instrument, however, is usually an exchange-traded fund, the DAX EX, which tracks the German blue-chip index.

The XLM does not play any role for certificates, funds and warrants since the issuers ensure liquid trading based on a previously determined volume.

For securities that do not have much liquidity, Designated Sponsors account for additional liquidity on the Frankfurt Stock Exchange. They issue quotes at which they are ready to buy or sell securities in their possession. They are prepared to take them on their own books in the case that there is no corresponding counterparty, whereupon the Xetra Liquidity Measurement determines for which securities the issuer has to enlist a Designated Sponsor.

In the supported trading on Xetra Frankfurt, specialists provide liquidity by offering bid and ask quotes with corresponding volumes.

By Dorothee Liebing and Edda Vogt
May 2011

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