Is Liquidity The Clinching Factor For A Windfall?

Written by Ke Xuan Tan

Liquidity defined

Market liquidity refers to the degree with which assets can be traded with ease on the market, due to high transaction volume, without causing excessive price movements. For instance, a highly liquid asset means there is almost always buyer demand and seller supply at any one time. When determining the liquidity of a market, one can view it as a continuum instead of drawing a binary conclusion[1] (See Figure 1).

Figure 1: Illustration of the liquidity continuum

Importance of a liquid market

Liquidity is crucial in a market because a lack thereof increases risk[2]. To illustrate, if there are fewer buyers than sellers in a market, closing positions become more difficult (shareholders’ value is locked). This may result in an investor to find himself/herself in a losing position, due to the inability to recycle capital.

Instinctively, it thus follows that a more liquid market tends to be more attractive to investors, increasing investor base which reinforces a positive cycle that promotes future market liquidity.

What drives liquidity?

We outline 4 factors:

• Growth of stock exchanges on a national level

Many domestic and regional companies prefer listing on exchanges where their operations are domiciled. In fact, more than 90% of issuers list on their domestic stock exchanges[3]. This is because such exchanges are intimately linked to the economy, culture, infrastructure, technology base and taxes of their home countries. As a result, many exchanges grow on a national level, focusing on local issuers and investors.

National growth of stock exchanges begets political risk. For example, in the heyday of Central Limit Order Book (CLOB), transactions surpassed those in Singapore Exchange. In September 1998, then Malaysia Prime Minister Mahathir banned the trading of Malaysian shares overseas on counts of Singaporeans subverting the Malaysian economy[4]. This caused share prices to plummet, leaving many Singaporeans vested in CLOB to lose a large portion of their wealth.

• Concentration of ownership

When a small number of shareholders wields a majority stake, there is key man risk[5]. This reduces the level of free float – shares that are actively traded in the exchange and are not locked up for whatever reason[6]. There will be fewer buyers and sellers for a particular stock.

• Nature of exchange

Established exchanges like NASDAQ tend to have stringent requirements for listing[7]. Listed companies are often required to make their assets easily understandable to investors through supporting references like 10Q, 10K, press releases etc. Exchanges are also regulated to uphold the accuracy of the information. Such are required to protect these exchanges’ reputation and enhance their popularity.

Companies listed on widely recognized exchanges tend to be larger names that are more well-known, improving their attractiveness amongst investors. As a result, they have a larger investor base which promotes liquidity.

• Improving market access

Globalization and the rise of institutional investors mean heightened demand for exchanges to provide an efficient gateway for investors to access the market. Technological implementations like internet trading, the inclusion of Direct Market Access (DMA) and open interface technologies (API) aid in this regard[8]. The end result is greater ease of participating in the market, encouraging liquidity.

[1] Damodaran, Aswath. “The Cost of Illiquidity.” Accessed May 31, 2019. https://people.stern.nyu.edu/adamodar/pdfiles/country/illiquidity.pdf.

[2] Goldberg, Matt. “Financial Times Liquidity Is an Important Variable in Our Portfolios.” Financial Times. August 24, 2018. Accessed May 31, 2019. https://www.ft.com/content/64dae80e-a553-11e8-8ecf-a7ae1beff35b.

[3] Steinbach, Martin. “How to Decide Whether to List in Your Home Market or Overseas.” EY – Global. August 22, 2018. Accessed May 31, 2019. https://www.ey.com/en_gl/growth/how-to-decide-whether-to-list-in-your-home-market-or-overseas.

[4] Shameen, Assif. “The CLOB Revisited.” CNN. October 26, 1999. Accessed May 31, 2019. https://edition.cnn.com/ASIANOW/asiaweek/intelligence/9910/26/.

[5] “Definition of Key Employee Or Keyman | What Is Key Employee Or Keyman ? Key Employee Or Keyman Meaning.” The Economic Times. Accessed May 31, 2019. https://economictimes.indiatimes.com/definition/key-employee-or-keyman.

[6] “What Is the “Free Float” of SGX Stocks?” SGX Observer. April 06, 2018. Accessed May 31, 2019. https://sgx.observer/2018/04/06/what-is-the-free-float-of-sgx-stocks/.

[7] “Initial Listing Guide.” January 2019. Accessed May 31, 2019. https://listingcenter.nasdaq.com/assets/initialguide.pdf.

[8] Peterhoff, Daniela. “Enhancing Liquidity in Emerging Market Exchanges.” 2016. Accessed May 31, 2019. https://www.oliverwyman.com/content/dam/oliver-wyman/global/en/2016/oct/Liquidity-in-Emerging-Markets-Exchanges-.pdf.