What the heck is "liquidity," exactly... providing, purchase, exactly

jcfa2011

Yes, I know more-or-less what liquidity means. But the problem is that it’s only “more-or-less.” I hear people talking about “adding liquidity” or “providing liquidity” or “liquidity driven” things like it’s the most obvious thing in the world.
In my mind, I think of liquidity as “the ability to convert an asset to cash quickly at close to the last quoted price.”
A corollary from the purchase side is “the ability to purchase an asset quickly at close to the last quoted price.”
There are several dimensions:
A: The quantity of an asset that gets converted. Converting larger quantities of an asset tends to have a larger impact on price at all levels of liquidity.
B: The speed at which the asset can be converted. The ability to distribute transactions over time reduces the price impact, but it also opens up risk to price changes from other factors in the interim.
C: The discount to the last price. The greater the price impact, the lesser the liquidity.
One version of this view (consistent with practitioners) is that the bid-ask spread is an indicator of liquidity, because if you buy something and immediately want to sell it, the BA spread tells you how much of a hit you must take on the price to turn around instantaneously.
But there are plenty of other times when people talk about providing liquidity that doesn’t really seem to fit into this view, and I wonder what I’m missing. HFT firms, for example, talk about “providing liquidity,” but in fact, that liquidity can disappear instantaneously, so are they really providing it? How are they making money, other than, perhaps, from each other.

manasib

way too academic. no need.
liquidity is pretty much what you describe. Its just having cash (i.e. funding for banks from posting collateral) when you need it. the problems you’re seeing is that they need huge sums of cash that the market isn’t willing to provide.

noel

FrankArabia Wrote:
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way too academic. no need.

liquidity is pretty much what you describe. Its
just having cash (i.e. funding for banks from
posting collateral) when you need it. the problems
you’re seeing is that they need huge sums of cash
that the market isn’t willing to provide.
he’s talking about market liquidity, not corporate liquidity (i.e. financial ratios for looking at ability to service debt; e.g. current ratio and operating cash flow ratio)

spartanag07

You’re talking about two different things. Your view of liquidity is something I think we can all agree on. “Providing liquidity” is something else altogether. That’s a phrase HFT have branded onto to their forehead in an effort not to be shut down.
From what I can tell, “providing liquidity” is really just quote stuffing, and doesn’t help anyone. To be fair, it doesn’t really hurt anyone either, until a flash crash occurs. Then it’s horrible.

robjames1984

One definition of providing liquidity is posting a limit order and waiting till you get hit/lifted. If you’re doing this on both sides (bid and ask), you’ll collect the spread if you execute on both sides. This is market making.
One definition of taking liquidity is executing via a market order and hitting a bit/lifting an offer. If you’re doing this, you’re paying the spread. One would only do this if they’re trading for alpha.
That said, you also seem to be trying to quantify liquidity and even predict it. That’s difficult and highly dependent on microstructure. One would definitely want to look at spreads, the depth of the order book, the commission structure of the ECN, etc.

SWASH

I think this is a really good question (and critically important topic for anyone at a hedge fund), and I’m not sure I can provide an answer but I’ll throw out this: the volume from high frequency traders is not adding true liquidity to the market. Volume goes up, but those guys can step away at any time, especially when things get really bad.

hassan

bchadwick Wrote:
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But there are plenty of other times when people
talk about providing liquidity that doesn’t really
seem to fit into this view, and I wonder what I’m
missing. HFT firms, for example, talk about
“providing liquidity,” but in fact, that liquidity
can disappear instantaneously, so are they really
providing it? How are they making money, other
than, perhaps, from each other.
When the firms are trading, they’re providing liquidity. When they’re not trading, they’re not providing liquidity. Most of them are under no obligation to trade constantly, and if they do turn off their trading, you would see a measurable decrease in liquidity.
Providing liquidity is generally a profitable endeavor, though not without risk. For instance, you can’t take one side of a trade forever and just build inventory. So, you might say you’re willing to take on a position up to some limit, whether that limit is based on average daily volume or % of the float or some other metric.

ap0258

The HFTs don’t provide anything and, in fact, take it since regular traders do not have the ability to micro trade and front-run those traders, taking profits from ordinary people.
Somehow the markets functioned well before HFT, I hope they outlaw it soon. The first step was the SEC requesting the algos.

kingstongal

spierce Wrote:
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The first step was the
SEC requesting the algos.
Step 2: SEC hiring people that understand the algos.

ayaz_mahmud369

spierce Wrote:
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The HFTs don’t provide anything and, in fact, take it since regular traders do not have the ability to micro trade and front-run those traders, taking profits from ordinary people.
Somehow the markets functioned well before HFT, I hope they outlaw it soon. The first step was the SEC requesting the algos.
Everyone does have the ability, perhaps not the means. Much like a seat used to cost a lot of money to lease - they are just a modern day version of the specialists and pit traders of old. This will always be a part of the market imo.