TRADE, FINANCE AND INVESTMENT COMPETITIVENESS FINANCE EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Liquidity In Corporate Markets: A Literature Review Ana Fiorella Carvajal and Ricardo Bebczuk © 2024 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy, completeness, or currency of the data included in this work and does not assume responsibility for any errors, omissions, or discrepancies in the information, or liability with respect to the use of or failure to use the information, methods, processes, or conclusions set forth. 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Cover photo: iStock Just_Super >>> Contents Foreword 4 Executive Summary 5 Section 1. Introduction 7 Section 2. Liquidity: Basic Concepts 9 Section 3. Liquidity Drivers: Survey of the Empirical Literature 11 Section 4. Liquidity Effects: Survey of the Empirical Literature 21 Section 5. Conclusions 22 Appendix A. Analysis of Key Liquidity Indicators Used in the Literature 24 Appendix B. Summary Findings from Papers on Liquidity 27 References 46 >>> Foreword This note is part of a series aimed at enhancing the public knowledge of key topics that are relevant for capital markets development. It does so by consolidating and reviewing the economic literature and empirical research on the impact and drivers of secondary market liquidity. Its primary audience is technical staff in emerging markets and developing economies who are involved in capital markets development programs and who want to pursue evidence-based policy. The World Bank expresses its appreciation to the Joint Capital Markets Program (J-CAP) and, in this case in particular, to the government of Norway, which has financially supported this review.1 The authors are Ana Fiorella Carvajal, lead financial sector expert of the Finance, Competitiveness and Innovation Global Practice (FCI) and Ricardo Bebczuk, consultant. The Note was produced under the supervision of Anderson Caputo Silva, while practice manager of the Long-Term Finance Unit. It was peer reviewed by Jose Antonio Gragnani, Zsolt Bango, and Tatiana Didier, all senior financial sector specialists from FCI, and by Anica Nerlich, associate financial officer from IFC. The authors thank them for their comments, which helped to enrich the note. 1. J-CAP’s in-country work is made possible by support from the governments of Australia, Germany, Japan, the Netherlands, Norway, and Switzerland. The governments of Luxembourg and Norway support J-CAP’s related knowledge work. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 4 >>> Executive Summary This note reviews the economic literature and empirical research on the drivers and effects of secondary market liquidity in the corporate securities markets. The choice of this topic was driven by the work of the World Bank in the field. Financial sector authorities in emerging markets and developing economies often request World Bank’s support to improve the liquidity of their corporate markets, as they consider liquidity to be key to attracting more investors. The empirical research confirms the benefits of liquidity for corporations. In particular, the research consistently shows that liquidity reduces the overall cost of financing, whether via stocks or bonds, and promotes greater use of equity and lower leverage. Furthermore, previous research by the World Bank found a link between liquidity and economic growth. The economic literature and the empirical research also offer guidance on the drivers of liquidity. They point to the importance of a wide range of factors that can be grouped into five broad categories: (a) the asset class, (b) the characteristics of the issuer, (c) the investors in the market, (d) other aspects of the structure and functioning of the capital markets, and (e) preconditions for capital markets development. a) Asset class. There is not much empirical research comparing and contrasting equity versus bonds. It is understood, however, that there are inherent differences between the two asset classes that have implications for their level of liquidity. In general, it is accepted that liquidity is more critical for equity markets, since secondary markets are the only exit available for equity investors. In fact, equity markets tend to be more liquid than corporate bond markets. b) Characteristics of the issuer. The empirical research has examined the characteristics of issuers and the extent to which they are conducive to liquidity. It has consistently found a correlation between size (of the company in the context of equity and of the issuance in the context of bonds) and liquidity. The empirical research has also consistently found a correlation between liquidity, good corporate governance, and low ownership concentration in the case of stocks and low credit risk, age, and maturity in the case of bonds. The relationship of other variables such as profitability, leverage, and asset tangibility to liquidity has also been explored, but the related research is more limited. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 5 c) Investors. The empirical research points to the benefits and a broad set of (large) companies (and issuances) with of the participation of a wide range of investors to boost “solid fundamentals.” Their presence in turn is affected by liquidity, including institutional, retail, and foreign investors, the structure and functioning of the capital markets, the as well as, more recently, high-frequency traders. Note, macroeconomic and institutional environments, and the level however, that for retail investors the research has focused of development of the financial sector. Thus, policy makers on equity markets, which likely reflects the fact that should consider a multidimensional approach to improving retail investment participation has not been prevalent in liquidity that incorporates the factors highlighted above and corporate bond markets—although this situation seems in this note. to be changing with the advancement of digitalization. Similarly, for high-frequency traders the existing research focuses on stock markets in advanced economies, also likely a reflection of market trends. Finally, the empirical research has also found a positive correlation between market makers and liquidity. d) Other aspects related to the structure and functioning of capital markets. Regarding microstructure issues, the empirical research has found a positive relationship between liquidity and analysts’ coverage, although the focus has been on stocks. Other aspects of market microstructure, for example, whether the market works on a continuous basis or on an auction basis, have not been the subject of econometric research. Finally, capital markets volatility has been found to be detrimental for liquidity. e) Preconditions for capital markets development. Previous research by the World Bank confirmed the relationships between the macroeconomic environment, the institutional environment, and the level of development of the financial sector, on the one hand, and liquidity on the other hand, including factors such as gross domestic product growth, the rule of law, the degree of political risk, and a well- developed banking sector. However, most of that research has focused on equity markets. Other key components of the financial sector that have been identified by economic theory and practitioners alike as crucial for liquidity—such as the existence of well-functioning repo and derivatives markets—have not been the subject of hard empirical research. Nevertheless, the lack of this research should not be construed as indicative of the lack of a relationship between the corresponding variable and liquidity, as explained in Section 5 of this note. The review leads to the conclusion that there are no easy and instant solutions to increase capital market liquidity. Liquidity will be a result of the presence of both a wide range of investors EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 6 >>> Section 1. Introduction This note consolidates and reviews the economic literature and empirical research conducted in the past 30 years on the topic of secondary market liquidity.2 Several hundred papers were reviewed, from which 123 were considered to be of high quality and were subjected to deeper analysis. Table 1 provides a summary of the characteristics of these papers. The selection of this topic responds to World Bank work in emerging markets and developing economies. Authorities often request World Bank support to improve the liquidity of their corporate markets, since liquidity is considered key to attracting more investors. Furthermore, a minimum level of liquidity is imbedded in key emerging market indexes as a precondition for a jurisdiction to be eligible to obtain such status. In this context, the World Bank has undertaken this review anchored by three fundamental questions: (a) What is liquidity and what indicators have been used to measure it? (b) Have the literature and empirical research dealt with the issue of preconditions and, if so, what factors have been identified as having an impact on liquidity? (c) Has the empirical research been able to demonstrate the benefits of liquidity? The answers, in turn, can better inform World Bank programs in the field, as well as planning by policy makers. Relatedly, this review would also help identify areas where the existing research is insufficient. The note is organized in five sections. This section provides an introduction. Section 2 focuses on the definition of liquidity, section 3 reviews the drivers of liquidity, section 4 explores the effects of liquidity, and section 5 provides conclusions. Appendix A describes the indicators used in the empirical research to measure liquidity. Appendix B provides a summary of all the papers reviewed. 2. This review has focused on the asset class, the issuer characteristics, the roles of different types of investors, and other aspects related to the structure and functioning of the capital markets. A companion paper (Carvajal and Bebczuk 2019) reviewed the macro-level drivers of capital market development at the aggregate level. That review highlighted the impacts of gross domestic product (GDP) growth and stability, the fiscal stance, the institutional framework, and the structure of financial markets on value traded and turnover, which are the most popular indicators capturing the degree of overall market liquidity within the macro literature. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 7 >>> Table 1.1 Research on Capital Markets Liquidity: Paper Classification No. of papers Classification criterion Group Share (%) (total = 123) Only advanced economies 67 54 Only emerging and 36 29 Country sample developing economies Both 20 16 Stocks 85 60 Asset class Corporate bonds 36 26 Government bonds 20 14 Liquidity drivers 80 64 Research question Liquidity effects 24 19 Only descriptive 21 17 2008 or before 21 17 Year of publication After 2008 102 83 Note: Some totals do not add up to 123 in all cases because some papers include multiple subcategories. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 8 >>> Section 2. Liquidity: Basic Concepts The economic literature constantly refers to market liquidity; however, the actual definitions used focus on the elements that affect liquidity of individual securities. 2.1 What is liquidity? While there is no single definition of liquidity, in general there is agreement that liquidity is the ability to trade a significant quantity of a security at a low cost in a short time (see Holden, Jacobsen, and Subrahmanyam 2014). As it involves size, cost, and time dimensions, liquidity comprises five characteristics (Ametefe, Devaney, and Marcato 2016): • Tightness: the cost of trading, even in small amounts, as reflected in the difference between buy and sell prices; • Depth: the capacity to sell or buy, given a certain bid-ask spread, without causing price movements unrelated to the arrival of new information relevant to the asset’s pricing; • Resilience: the speed at which buy prices increase and sell prices fall as trading quantities increase; • Breadth: the overall size of the volume traded, independent of the prices at which transactions take place; and • Immediacy: the cost (discount or premium) charged to execute sell or buy orders quickly. Theoretically, the benchmark against which to judge these effects is a perfectly liquid asset whose price would be the same regardless of who buys or sells, how much is transacted, or how long it takes to complete the transaction. However, a number of imperfections affect the actual functioning of securities markets that may hold back the demand or supply of liquidity (Vayanos and Wang 2013). These market failures can be classified as follows: EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 9 • Participation costs: In a perfect market, every seller has • Search costs: As opposed to the centralized marketplace immediate access to a buyer, and vice versa. In reality, in the benchmark case, over-the-counter markets impose though, market participation entails costs of learning the cost of searching for a counterparty. about an asset’s upside and downside and about market fluctuations to time the transaction. Because investors may not find a counterparty after incurring these costs, 2.2 How is liquidity measured? they may as a result require compensation—a liquidity premium. Liquidity is not directly observable, a matter which ultimately • Transaction costs: Executing transactions involves the calls for the use of empirical proxies. Because of the payment of brokerage commissions, transaction taxes, multifaceted nature of liquidity, both quantity-based and price- and bid-ask spreads, which drive a wedge between the based liquidity measures have been constructed (Hameed buying and selling prices. et al. 2019). The quantity-based measures intend to gauge • Asymmetric information: Unlike a frictionless market, in the intensity of trading, whereas the price-based indicators practice some investors may possess better information seek to capture the price impact of such trading activity. The than others about asset payoffs. Aware of this, investors Appendix provides an overview of the key indicators in each with inferior information may require an extra return for category, including their features and drawbacks. trading against the other group. In practice, the empirical research has made much more use of • Imperfect competition: A liquidity premium may also price-based indicators. Furthermore, among all the indicators, be required as investors feel at a disadvantage against the quoted bid-ask spread and the Amihud measures of other investors that may exert market power, far from the illiquidity have been more extensively employed than others competitive paradigm of every individual investor’s being (see table 2.1). In spite of the multiple indicators available, a price-taker. a close association has been found between most liquidity • Funding constraints: Traders may sometimes need to indicators and actual transaction costs (see Goyenko, Holden, borrow cash to establish a long position or to borrow and Trzcinka 2009). securities for short selling. As much as access to these external resources may be limited, the ability to transact securities can be seriously curtailed. >>> Table 2.1 Empirical Literature on Capital Markets Liquidity: Paper Classification No. of papers Classification criterion Group Share (%) (total = 123) Amihud 53 25 Quoted bid-ask spread 57 27 Turnover 27 13 Liquidity indicator Trading volumen 28 13 Zero return days 19 9 Effective bid-ask spread 16 7 Roll 14 7 Quantity based 74 35 Type of liquidity indicator Price based 140 65 Note: Totals do not add up to 123 because most papers include multiple liquidity indicators. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 10 >>> Section 3. Liquidity Drivers: Survey Of The Empirical Literature The literature and empirical research on the drivers of liquidity is abundant, although as previously indicated, it is tilted toward the equity markets. However, one drawback is the absence of a unified framework to help assess the attributes of different factors that can foster or hamper market liquidity and that can then be contrasted with the empirical research. To address this gap, this note develops a conceptual framework underpinned by the very nature of trading as a business or activity that involves risks, in which the investor makes a gain or a loss by buying (or selling) a security and then selling (or buying) it at a future date.3 As with any decision made under uncertainty, the higher the expected profit (net of transaction costs) and the lower the risk of major security price movements, the more willing the investor will be to trade, and thus the more liquid the market should be.4 In this context, any given variable can spur trading and liquidity by one or more of the following three channels, everything else being equal: (a) reducing transaction costs, (b) increasing expected returns, or (c) reducing risks.5 3. It is important to acknowledge that any conceptual framework has limitations. In this case, note that the nature of the investors (and their obligations) has an impact on their willingness and need to trade. This factor is not captured in the framework. 4. If the investor is on the buying (selling) side, the expected profit is the difference between the expected future selling (buying) price and the actual buying (selling) price. Risk, in turn, is defined as the range of future prices with positive probabilities of occurrence. For example, if the investor buys a security at, say, $40 and believes they can sell it later at either $38 or $45 with equal probabilities, there’s both an upside and a downside risk—the latter, of course, being the one more likely to deter trading. But if, for whatever reason, the investor now believes that the future price can be either $25 or $50 with same 50-50 chance, one would say that the transaction has become riskier. This larger expected price dispersion would discourage the typically risk averse investor from participating in the market. The argument works similarly for an investor on the selling side. In other words, for all practical purposes, high liquidity is akin to trading intensity. There are, of course, other liquidity measures, which were introduced earlier, but they are not widely available across countries, time, and issuers. Here, the emphasis is on popular indicators such as value traded and turnover and, to a lesser extent, others like the number of trading days, which is of utmost interest for study of individual securities that are traded intermittently. 5. Reinforcing the previous explanation, risk here refers only to the future fluctuation of security prices. Therefore, it is not linked to other sources of risk, such as credit, operational, or liquidity risk. Note that this approach is fully consistent with the traditional view that differences of opinion among heterogeneous investors lie at the heart of the decision to trade (see, for example, Goetzmann and Massa [2005] and Hong and Stein [2007]). After all, if all investors were rational and identical in terms of their access to total relevant information and the way they process it, then the incentives to trade would vanish for the most part, since the investors would agree on the same equilibrium asset prices and expected returns. In the simplest terms, the lack of disagreement would render impossible the goal of buying low and selling high. In practice, though, expected returns and risks are not homogeneous across investors because of differences in the information set available to each investor and what they make of it; not only irrational but also rational individuals may price the same information differently. In fact, the present analysis takes for granted that disagreement exists, implicitly assuming that it is a necessary but not sufficient condition for trading. Trading is triggered also by market- and asset-specific return and risk considerations in addition to different opinions. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 11 Thus, this risk-return lens allows assessment, within a single, in the following: (a) the rational assessment of micro and intuitive, and consistent model, of the main drivers of market macro fundamentals, (b) psychological factors and market liquidity and the channel(s) through which they operate.6 sentiment, or (c) asymmetric information risk, stemming from By this logic, any variable postulated as liquidity enhancing a situation in which the investor fears that the counterparty is should lead to a larger risk-adjusted expected trading better informed, so the security being sold (bought) is actually profit—motivated by any of the three elements (gross return, underpriced (overpriced). transaction costs, or risk)—and hence should encourage investors to engage in new transactions.7 The variables that can explain market liquidity can be classified into five categories, namely: (a) asset class, (b) A corollary of the framework presented is that even if characteristics of the issuer, (c) investors in the market, (d) transaction costs were somehow driven to zero, that would structure and functioning of the capital markets, and (e) not necessarily result in a liquidity boom, as other factors drivers of capital market development. Table 3.1 summarizes affect the investors’ evaluation of risks and returns and the theoretical effects of the most prominent liquidity drivers thus their willingness to trade.8 These factors can be rooted identified in the literature. >>> Table 3.1 Theoretical Drivers of Capital Markets Liquidity Overall theoretical effect on Category Variable market liquidity Stock +/− Asset class Corporate bonds +/− Government bonds +/− Profitability and solvency + General Asset tangibility + Issuer characteristics Size + For equity issuers Governance and transparency + Ownership concentration − Credit risk +/− For bond issuers Maturity and age − Issuance size + Institutional investors +/− Retail investors +/− Market participants Foreign investors +/− High-frequency traders +/− Market makers + Capital markets volatility +/− Other aspects of the structure and Internationalization +/− functioning of capital markets Analyst coverage + 6. One indirect implication of this framework is that liquidity should be procyclical, rising in good times and plummeting in bad times, as good times heighten expected returns and reduce perceived risks. Galariotis and Giouvris (2015) and Næs et al. (2011) provide some favorable international evidence in this direction. 7. It should be acknowledged that, at least in the medium term, transaction costs are not fully independent of the risk-return mix of a security: if the latter is not appealing enough for a long time, trading in this security will become thinner and thinner, so in time it will be increasingly difficult and costly to find a counterparty. The argument works symmetrically, in the sense that coveted securities will become easier to negotiate. 8. In fact, the same can be argued of other financial contracts. For example, what would happen if all intermediation costs associated with the extension of bank loans were suddenly eliminated? Would this noticeably speed up credit growth? Most observers would agree that this would be a step forward, but it would not be enough to unleash a credit boom, because other key macro, financial, and institutional conditions need to be met to fuel both the demand and the supply of loans. As a matter of fact, in the empirical literature on both private credit and capital market development, transaction costs are not a central explanatory piece—and not only because of the practical difficulties of measuring such costs. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 12 Preconditions for capital markets GDP growth and level + Macroeconomic instability +/− Macroeconomic environment Fiscal deficits and debt +/− Expansionary monetary policy + development Legal investor protection + Institutional environment Rule of law and political risk + Banking system development + Financial market structure and Repo market development + stability Derivatives market + development A discussion of each proposed driver, along with a summary of These frictions are magnified in the case of unlisted shares, the associated empirical research, is presented below.9 which are not subject to the strict governance and disclosure requirements applicable to listed securities. In consequence, ASSET CLASS as discussed below, good internal and external transparency and governance standards are needed for investors to Trading intensity is not expected to be the same across all gravitate toward stocks. asset classes (stocks, corporate bonds, and government bonds), as their tradability depends, among other things, on Corporate bonds. Ruling out default risk, the pricing risk of their intrinsic risk and maturity characteristics.10 debt is bounded because the interest rate imposes an upper limit to gains (that is, bond risk lies with the discount rate, not Shares. Overall, it is likely that liquidity should be greater for with the coupon and principal payments).12 Adding to its risk stocks than for bonds. This is because of the very features of mitigation properties, the low covariance with equity makes for the share contract, in which maturity is not predetermined, risk a valuable portfolio diversification tool. This comes at the price is shared (both the upside and the downside), and there is of lower expected returns than stock—a wedge that has been no fixed obligation to remunerate the investor. This all means coined the equity premium. that, relative to debt, equity contracts are riskier and longer term. Under these conditions, trading is the only exit door for Government bonds. Government bonds share the attributes shareholders having second thoughts about future security of corporate bonds, although two elements set them apart: performance. Thus, in the same vein, lacking or sporadic (a) the default risk is lower (yet not zero) as a result of the trading is bound to stifle the interest of investors who have low government prerogative to raise taxes and issue money during risk tolerance or are likely to be cash-strapped at some point.11 financial distress and (b) as will be indicated in reference to the role of the fiscal debt, the government bond market Notwithstanding the above, compared with fixed income, is likely to exert a first-order impact on the development of stocks imply greater return potential but also more risk, with capital markets and the lowering of transaction costs. All unclear overall effects on market liquidity. This risk stems things considered, this asset class may increase liquidity not only from the absence of downside protection but also by containing risk and transaction costs but less so when it from the hurdles facing minority shareholders in monitoring comes to searching for yield. cash flows and avoiding expropriation (tunneling) by insiders. 9. An online annex lists all the empirical research reviewed and summarizes the key findings of each paper. 10. The liquidity differences across asset classes stem from contractual features which, to some extent, interact with some issuer and bond characteristics examined below. However, despite being a cross-cutting issue, their legal particularities are worth a separate discussion. 11. In fact, on practical grounds, not all listed stocks are liquid, because liquidity is concentrated in relatively few stocks. Related to the cost of immediacy for small orders, the tick size has been found to exert a statistically significant effect on liquidity (see, for example, Chung, Lee, and Rösch [2020]). 12. Moreover, in a bankruptcy scenario, the ability to claim ownership of a firm (plus collateral in the case of secured debt) mitigates the loss. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 13 There is very limited empirical research comparing stocks Governance and transparency. Better corporate and bonds in terms of their liquidity.13 However, overall, at governance is believed to improve liquidity by upgrading the global level, stocks are much more intensely traded than the informational transparency of a firm. Greater and better corporate bonds—in line with the analysis above, which as disclosure of information to the market has the effect of stated indicates that liquidity is more important for equity alleviating information asymmetries between inside and investors given that secondary markets are their only exit from outside investors. Outside investors are reluctant to trade these investments. with counterparties that may be in possession of better information. In other words, under adequate standards of corporate governance and information disclosure, investors ISSUER CHARACTERISTICS can be relatively confident that transactions will occur at a fair price and that information-based risks are in check, spurring Several characteristics of the issuer can have an impact on trading and reducing transaction costs. Econometric evidence liquidity. A priori, some of them seem to be applicable to both confirms the positive nexus with liquidity. equity and bonds, although their importance might differ.14 Ownership concentration. For listed companies, the Profitability. All else being equal, more-profitable firms are presence of concentrated ownership directly reduces the more likely to provide traders with higher returns, lower risk number of common shares available for trading and hence levels, or both, at least in normal times when fundamentals- can lower stock market liquidity. In addition, stock market based valuations prevail. There is limited empirical work on liquidity may be jeopardized by the more intense information this topic, all focused on stocks, which supports a correlation asymmetries foreseen by potential traders, stemming from between profitability and liquidity. the existence of large shareholders in possession of private information. This situation exacerbates insider-outsider Asset tangibility. Tangible assets are much easier for outside conflicts and thus raises adverse selection concerns among investors to value and monitor and thus are less prone to minority investors and market makers alike. In consequence, tunneling by controlling shareholders. Therefore, when firms with fewer shares in free float tend to display lower information frictions are mitigated, investors should be more investor participation in capital markets and higher bid-ask attracted to trade tangible-asset-intensive firms.15 The research spreads. The available empirical work lends support to the on this topic is limited, all focused on stocks, and has confirmed negative effect of ownership concentration on liquidity. the relationship between asset tangibility and liquidity. Leverage. Debt reliance may theoretically have divergent For equity issuers effects on liquidity. On the one hand, issuing debt increases the interest burden and therefore the riskiness of a firm when Size. Larger issuers, which tend to be older as well, have an faced with negative shocks. In other words, debt obligations established dividend and debt payment track record achieved are fixed, but cash flows are not. Therefore, by becoming through good and bad times, which should put risk-averse riskier, more-leveraged firms may end up being less liquid. traders at ease by providing stable payoffs over the business However, on the other hand, it is argued that leverage forces cycle. This risk-reducing effect is usually compounded by the managers to make better investment decisions to avert default, stronger corporate governance and accounting standards thus increasing the liquidity of the firm’s stock. Furthermore, displayed by larger companies, as highlighted later in this the very ability to access the banking system may be read section. This thesis finds support at the empirical level. as a positive signal for a company’s overall quality, spurring 13. There are very few papers comparing stocks and government, but not corporate, bonds (see Goyenko and Ukhov [2009] and Chordia, Sarkar, and Subrahmanyam [2005]). About bond liquidity, Bessembinder and Maxwell (2008) cite data on the much lower liquidity of corporate bonds vis-à-vis government bonds in the United States. 14. For example, profitability hits equity returns more than bond returns, as the latter are predetermined and not tied to businesses’ net income, unless debt repayment is compromised. Asset tangibility is of major importance for bondholders, as tangible assets can be seized in the event of default. However, bondholders are likely to positively value high-profit firms (as they imply lower default risk), whereas shareholders may covet stocks from companies abundant in tangible assets (as they make valuation easier and more reliable). Note, however, that in both cases the existing empirical research has focused on equity markets. Other characteristics seem to be much more applicable to one specific asset class and thus for presentational purposes they have been classified accordingly. 15. The expansion of economic activities intensive in intangible assets in the past few decades, notably in the field of informatic technologies, has rendered this argument less compelling than in the past, since some of the most successful and liquid listed firms nowadays indeed display low levels of asset tangibility. However, the fact remains that this is a rather small group of companies. For most intangible-intensive start-ups and younger businesses, this may still be a nonnegligible issue. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 14 liquidity. The limited empirical research on this topic has found on-the-run) bonds. The latter, on the contrary, are more likely a positive relationship between leverage and liquidity (that is, to draw widespread attention and so are more actively traded. higher-leverage companies are more liquid).16 In conclusion, traders holding longer and aging bonds should find it harder to identify a counterparty to complete the trade, For bond issuers implying that transaction costs will be steeper. The correlation between these bond characteristics and liquidity has been Issuance size. Smaller issues do not appeal to institutional corroborated by the empirical research. investors seeking to acquire large positions. Given this massive demand for larger issues by a broad class of major investors, larger bonds attract more attention and potentially MARKET PARTICIPANTS receive wider analyst coverage, alleviating uncertainty and information asymmetries that face potential traders. The Institutional investors. Institutional investors are not a empirical work supports a relationship between issuance size monolithic class; rather, depending on their type, they may and liquidity. affect liquidity differently.17 For example, institutional investors may hinder liquidity if they follow buy-and-hold strategies Credit risk. A priori, the credit quality of a bond has an or if they drive away other investors, disheartened by the ambiguous relationship with liquidity. On the one hand, low- presumption that institutional investors are better informed grade issues may induce more trading, fueled by speculation than the rest.18 Also, like every other investor group (retail about changes in the bond’s credit quality around earning and foreign), they may display herding, in which traders announcements or major macroeconomic news, with positive imitate each other and bunch up on one side of the market, impact on bondholders´ returns. On the other hand, low credit thus exacerbating volatility.19 Conversely, institutional ratings amplify not only the likelihood of extremely adverse investors may bolster liquidity both directly (as they may trade payoffs (downside risk) but also information frictions, thus intensively to keep a well-diversified portfolio) and indirectly bringing creditors and borrowers into conflict. This all makes (by keeping a vigilant eye on the issuers with whom they invest assessment of creditworthiness much less reliable, and thus their money). Furthermore, in the context of equity, provided the trading payoff is riskier. Empirically, credit risk has been that they exert shareholder activism, institutional investors found to correlate negatively with liquidity, whereby higher may invigorate liquidity by raising the standards of corporate credit risk issuers are less liquid. governance and transparency, first within the issuers whose securities they have in their portfolios. This monitoring should Bond maturity and age. Bonds with longer remaining mitigate the risks perceived by other, minority investors and maturity trade less because they are coveted by institutional push them into intensifying their own trading activity. In the investors with long-dated liabilities looking to reduce maturity best scenario, this upgrade would stimulate other issuers, mismatches for their buy-and-hold portfolios, which leaves who are competing for the same shareholder base, to move lower volumes to trade. The same applies to bonds becoming in a similar direction. Finally, for both equity and bonds, the more seasoned (or aging, as measured by the number of institutional investors may be instrumental in jump-starting the years since they were first issued), which are more likely to market and may bring transaction costs down by virtue of their be absorbed by institutional investors than recently issued (or massive size and trading volume—an argument that extends, 16. The results of this research seem at odds with the key findings from the existing research on the impact of liquidity on firms (summarized later in this paper). This apparent contradiction is possible because the research on leverage is part of broader, multivariate exercises involving many regressors in addition to leverage. 17. Although beyond the scope of a broad survey like this one, it is worth noting that the impact on liquidity may vary between different institutional investors, and even at the interior of a particular institutional investor class. For instance, among pension funds, serving members in the accumulation phase will probably display a larger allocation to equity and long-term instruments in general, whereas members in the payoff phase will be more biased toward short-term fixed income. Similar distinctions can be made between defined contributions versus defined benefit schemes and between those operating in countries with liberal investment guidelines versus those in countries with more draconian portfolio regulations, where allocation to some local and foreign assets is severely restricted. 18. Note that in principle the buy-and-hold strategy may be an optimal rule for some investors and is not bound to cause market illiquidity. This will only be the case in thin markets with an initial narrow set of investable securities, limited aggregate liquidity, and few and highly concentrated players. In more developed markets, buy-and-hold options by some investors should not have a serious market-wide liquidity impact. 19. Herding can be irrational (investors ignore their own information set and beliefs to follow the crowd, assuming that other investors have superior information) or rational (driven by widespread identical reactions to public information on fundamentals). Irrational herding may be particularly destabilizing and give way to market inefficiency and financial bubbles, impairing the proper functioning of capital markets. For examples, see Broeders et al. (2021); Blake, Sarno, and Zinna (2017); and Kremer and Nautz (2013) on the theory and evidence regarding institutional investor herding. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 15 for that matter, to any large investor group (foreign or retail). supports a positive role played by retail investors on market The existing empirical research has found that institutional liquidity. Note that this research has focused on the equity investors have a positive effect on liquidity.20 markets—which to a large extent is explained by the fact that corporate bond markets have overall been markets for Foreign investors. Akin to the institutional investors’ case, institutional investors, with more limited presence of retail conflicting effects can be expected from an increased investors—though the situation might be different on a presence of foreign investors, depending on how well- country-by-country basis. informed they are and what their intended trading strategies are. If foreign investors are better informed than local traders, High-frequency traders. The advent of high-frequency the latter will have less incentive to participate in the market, traders, who rely on computerized algorithms to execute curtailing liquidity. However, the presence of foreign investors automated trades within milliseconds, has the potential may be taken by domestic investors as a sign of good trading to increase or decrease liquidity. Because these traders opportunities. Then again, if foreign investors follow buy- can easily detect order imbalances or transitory arbitrage and-hold strategies, rather than searching for short-term opportunities, they may be liquidity providers by acting as yield, liquidity may be negatively affected. The vast majority voluntary market makers. Reinforcing this positive effect, they of the empirical research, which centers on investments in are able to quote smaller bid-ask spreads than other market emerging markets, favors a positive effect of foreign investors makers because of the lower level of adverse selection and on liquidity, suggesting that they are mostly short-term traders better inventory management enabled by their continuous and that they crowd in rather than crowd out local investors. market monitoring and high-speed reaction to news. The opposing view is that high-frequency traders may create Retail investors. The hypothesis that greater retail participation information asymmetries that end up drying liquidity from the brings about higher trading volume, lower transaction costs, market, because their anticipatory trading may discourage and increased liquidity pivots on the notion that investors are other investors from participating (since they face lower-return/ rational. However, there is a wealth of research pointing to higher-risk prospects in competing with the ultrafast traders). evidence that investors may display behavioral biases that Adding to this, their focus on intraday profits and their potential depart from the paradigm of full rationality. For instance, they herding behavior (because they all use similar computer may be overconfident in their own trading skills, excessively programs) may cause extreme movements in security prices. influenced by the media, or both, leading them to trade too The bulk of the existing empirical evidence leans in favor of a much, too poorly, or both, and in the end underperform the positive impact of high-frequency trading on liquidity.22 Note market.21 The effects of irrational or noise traders on stock that all the existing research has been conducted in advanced prices and market efficiency are a central issue in finance economies, which could be explained mostly by the fact that scholarship. The traditional belief is that these irrational (or high-frequency trading is a recent phenomenon which started noise) traders will not survive because they will be inflicted in these markets. with heavy trading losses against rational, informed investors. However, this traditional view has come under criticism, as it has been argued that noise traders can have a persistent O T H E R A S P E C T S R E L AT E D T O T H E effect on stock prices by driving rational traders away from STRUCTURE AND FUNCTIONING OF the market before market efficiency (in which prices reflect T H E C A P I TA L M A R K E T S all available information and are aligned with fundamentals) is restored. When market efficiency is jeopardized, security Capital markets volatility. By undermining the ability to returns may become too volatile and unpredictable, causing assess the creditworthiness of most prospective issuers, many investors with low risk tolerance to withdraw from the volatility exacerbates the degree of informational frictions, market. As far as the evidence goes, the empirical research the prime deterrent to investor participation. Thus, in general, 20. Most liquidity studies based on data from the United States treat institutional investors as a whole, without distinguishing between pension funds, insurance companies, mutual funds, and others. Europe-based research pays special attention to pension funds. However, in the few studies that separated institutional investor types, the liquidity-promoting effect holds for the whole industry and for each particular type. 21. It is important to highlight that more trading is not necessarily better. Neither light nor heavy trading is good or bad in itself. Investors must choose the style that fits their needs and preferences, and the market should be ready to provide the liquidity required to reach such goals. 22. As explained earlier, the fact that the majority of papers unveil a positive effect does not mean that there’s an undisputed consensus. In fact, a number of papers do find that retail investors act as a noise trade in some circumstances. As new evidence is produced steadily, the jury is still out. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 16 aggregate and idiosyncratic volatility tend to drain liquidity, lead no guarantee that other investors will be available to buy (sell) to soaring transaction costs, and bias portfolio choices away it immediately and in the amount desired. By standing ready from riskier instruments such as equity—the natural candidate to buy or sell securities on demand, market makers are called for frequent trading, as stated above—and into cash and other to play a critical role as liquidity providers. These services safer and liquid assets. Countervailing this liquidity-stifling involve costs that are reflected in the bid-ask spread—that effect, market volatility might create high-return/high-risk is, the compensation for providing immediate liquidity (order opportunities, so the issue remains unresolved on theoretical processing costs), the need to hold inventories to fulfill this grounds. At the empirical level, there is strong evidence of a task (inventory costs), and the costs of potentially dealing with detrimental impact of market volatility on liquidity. better-informed traders (adverse selection costs).25 In sum, market makers create liquidity by serving as intermediaries Compounding this issue, instability is usually accompanied by that make possible transactions that would not take place commonality. Commonality refers to the synchronicity of an otherwise. Applied research confirms this, in particular for individual asset’s liquidity with aggregate liquidity, including government bonds and, to a lesser extent, corporate bonds. cross-effects between domestic stock and bond markets as well There is also research on the benefits of market makers for as local and foreign markets. This implies that market liquidity equity markets, but mostly for advanced economies. is likely to be impaired when most needed—that is, in market downturns and times of crisis. Commonality can arise from Analyst coverage. Trading by investors who possess superior supply and demand factors. The main supply-side argument information may impose nontrivial costs on other market is that market makers face harder funding constraints when participants because of adverse selection. This informational markets decline, undermining their ability to provide liquidity. barrier lessens with the number of analysts researching and The main demand-side explanation is the presence of waves producing information about the value of the firm and its of investor sentiment and herd behavior. Most empirical probability of default. Reinforcing this effect, the intensity of studies demonstrate the presence of commonality.23 the analyst coverage may convey a positive signal about the company’s prospects, attracting additional investor attention.26 Internationalization. The migration of stock trading from local The empirical work unveils a positive effect predicted by theory, to international markets via cross-listings and related vehicles although most of this research has so far focused on stocks. may draw off domestic liquidity. On top of the direct effect on these securities, it might also generate a negative spillover on the market as a whole by increasing, via the fixed costs P R E C O N D I T I O N S F O R C A P I TA L of operating a market, overall transaction costs. Alternatively, MARKETS DEVELOPMENT as internationalization provides a positive signal about firm quality, it can attract new domestic and foreign investors into Previous research by the World Bank analyzed the relationship the local market, with the resulting positive spillover for other between the macroeconomic environment, the institutional securities.24 The majority (though not all) of the empirical environment, and the level of development of the financial research supports a positive effect on liquidity. sector on capital market development and liquidity.27 This Market makers. Traders who wish to sell (buy) an asset have note follows up on such analysis, adding also other specific 23. See Chordia, Sarkar, and Subrahmanyam (2001); Goyenko and Ukhov (2009); Hotchkiss, Warga, and Jostova (2002); Będowska-Sójka and Echaust (2019); Galliani et al. (2014); Chen and Poon (2008); Pino Izquierdo (2017); and Javid and Khan (2019), among others. 24. Besides the direct effect on liquidity, the international openness of capital markets contributes to market efficiency, as long as investors are rational and currency, tax, and regulatory barriers enable arbitrages across borders. 25. It follows that market making involves rather obvious risks. First, there is the financial cost and trading risk of holding excessive inventories, which is necessary to meet the demand for securities in a timely manner. Second, market makers can suffer trading losses when facing a better-informed counterparty. Importantly, by virtue of the major risks to which they are exposed, market makers require funding to perform their task. When credit markets dry up, as occurs commonly in crisis events, market liquidity will likely be severely curtailed as well. In the face of these risks, the national debt management offices and central banks can support the activity of market makers and mitigate their potential losses by providing securities lending facilities and accepting nongovernment bonds as collateral in repo transactions, among other policy instruments. 26. As with some other liquidity correlates, establishing the direction of causality is not straightforward: more analyst coverage may raise liquidity, but that can feed back into more analyst coverage, as security research gravitates toward more popular assets. 27. Carvajal and Bebczuk (2019) reviewed the theoretical and applied research on the macroeconomic, macrofinancial, and institutional drivers of capital markets development, including liquidity, as measured by value traded and turnover. The majority of the macro-level studies exploit World Bank’s Global Financial Development Database, and this dataset reports stock value traded and turnover but not the corporate bond counterpart, presumably because of the lower level of trading and public availability of bond liquidity measures. As a result, this data constraint tilts the evidence at hand toward stock markets. On the positive side, the Global Financial Development Database has very broad coverage of both advanced and emerging markets and developing economies over time. Notwithstanding the above, the absence of empirical research should not be construed as indicating that these issues do not matter for corporate bond markets. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 17 features of the financial sector that the economic literature and financing needs and the fact that government debt is more practitioners have considered important for liquidity. immune to the trust issues that plague corporate securities, this effect might be equally considerable. The downside is Macroeconomic environment that government bond issuance may crowd out private sector issuance and liquidity, partially counteracting the previous GDP growth and level. A thriving economy should increase market size effect. The majority of the available research has market liquidity by way of the three transmission channels. First, found a positive effect of liquid government bond markets on a thriving economy is associated with stronger cash flows and the size and liquidity of capital markets.29 thus better future returns, explained by both fundamentals and market sentiment. Second, transaction costs should decline Expansionary monetary policy. Accommodating monetary because both high per capita income and economic upturns policies at times of crisis may contribute to support liquidity bring about more private saving and, other things being equal, by relaxing financing constraints that may prevent traders a larger volume of transactions in capital markets, giving rise and market makers from participating in capital markets. to economies of scale in the use of trading infrastructure along With such policies, monetary measures may indirectly reduce the various links of the value chain. Finally, risks diminish, in transaction costs. Specifically, a conventional expansionary particular the likelihood of adverse scenarios—the so-called (contractionary) monetary policy is anticipated to reduce downside risk.28 Applied work on this matter, which has (increase) the cost of margin borrowing of traders and facilitate focused on stocks, has found a positive effect on liquidity from (deter) funding liquidity. Furthermore, unconventional monetary both the GDP level and the growth rate. policies (in which central banks make massive purchases of securities listed on capital markets, as occurred in a number of Macroeconomic instability. Episodes of macroeconomic countries in the wake of the 2008–09 economic crisis and the volatility are accompanied by the perception of larger risks COVID-19 pandemic) are designed to support valuations and in the valuation of financial assets as well as more-acute contain market volatility, thus reducing transaction risk. This information asymmetries, which are a prime factor behind the type of monetary policy is tantamount to introducing a large, level of transaction costs. The counterargument, though, that committed buyer into the financial markets of the securities volatility opens up attractive investment opportunities with targeted by the program, which strengthens the bargaining abnormally high returns can be made. In all, the theoretical power of sellers relative to buyers. Econometric evidence, outcome is unclear. However, most of the empirical literature, which has focused on advanced economies, provides support which has focused on stocks, supports the idea that macro for the positive impact of expansionary monetary policies on instability has a detrimental effect on liquidity. liquidity, especially during crises.30 Fiscal deficits and debt. Fiscal deficits and debt have mixed Institutional environment effects on both the level of risk and transaction costs. For one, they are key in creating a vibrant sovereign debt market at Legal investor protection. In order to provide investors different maturities. Such a market mitigates trading-related with the confidence to put their money into firms they do not risks by (a) making available to investors low-risk, low-yield know and to give them assurance that their contractual rights government bonds and (b) providing, by way of a yield will be enforced if needed, legal protection is a precondition curve, benchmarks against which to correctly price corporate for investor participation in financial markets. The nature of securities. However, unmanageable fiscal borrowing may end this protection differs according to the type of contract. In up increasing aggregate risk. With regard to transaction costs, debt contracts, including loans and bonds, creditors look to the government debt market plays a catalytic role in sustaining recover as much money as quickly as possible in the event a minimum threshold of trading volume and liquidity to jump- of default. In equity contracts, the legal protection should start and then expand the private market, thus reducing unitary strive to safeguard minority shareholders (the outsiders) from transaction costs. Given the usually massive government expropriation at the hands of the controlling shareholders (the 28. A growing, stable economy also acts as a pull factor in attracting foreign investors, thus enlarging the investor base. 29. See Carvajal and Bebczuk (2019). Note that most of the research has focused on issuance volumes as the proxy to determine the impact of government bond markets in capital markets. This proxy has limitations because the size of the government bond market per se is not a true indicator of the depth and liquidity of such markets. Furthermore, independent research conducted by World Bank obtained ambiguous results. 30. Partly countervailing this positive effect, it must be noted that these asset purchase programs turn the securities held by the central bank illiquid. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 18 insiders) by ensuring effective voting participation, proper standards of corporate governance, and access to timely and Repo market development: Repos support market makers’ transparent information on business affairs. But no matter the activity, as dealers must have the actual securities to satisfy asset class, legal protection shields investors by containing client long or short demand, either through outright ownership risks and enhancing gross returns. The available research, or by sourcing it via reverse repo.31 In addition to supporting which has focused on stocks, endorses the claim that a proper market makers’ activity by economizing on the level of direct legal environment boosts liquidity. ownership of bonds, repos, and more specifically securities lending play a critical role in enabling investors to take Rule of law and political risk. Over and beyond specific short positions. These functions suggest that, in facilitating legal protection for investors, the country’s overall institutional transactions that would otherwise be extremely costly, if not foundations—as measured by indicators of rule of law, control unfeasible, repo markets should be conducive to greater of corruption, political risk, and so on—are also relevant. The market liquidity. Empirical work is yet to be developed.32 confidence in and enforcement of property rights as well as the absence of crime and violence are prerequisites for sustained Derivatives market development. The use of derivatives willingness to trade in capital markets by way of narrowing (such as options and futures) can help manage the risk down the risks involved and possibly enhancing returns. The of holding the underlying assets, which may attract more- empirical research, which has focused on stocks, supports the sophisticated investors to participate in the spot securities relationship between these institutional aspects and liquidity. markets.33 Moreover, when investors disagree on the downside potential of the stock, those with low (high) risk tolerance will Financial Market Structure sell (buy) the stock and buy (sell) the derivative, with the effect of increasing the aggregate demand for the underlying stock.34 Banking system development. There is a consensus that By the same token, derivatives provide a valuable hedging tool capital markets are not likely to develop if a country has to market makers, which translates into lower bid-ask spreads. not been able to build a deep and solid banking industry. However, although the literature refers to the positive effect of Financial intermediation usually starts with simple deposit derivatives on liquidity, the empirical research is scarce.35 and loan contracts, and it only later gains more complexity and sophistication as trust between investors and borrowers Table 3.2 summarizes the theoretical priors and the consensus consolidates. Relatedly, having a long-lasting lending empirical findings from this literature review. The full list of relationship with the banking system stands as a credible signal papers supporting the empirical signs and the key findings of of creditworthiness for stock and bond issuers seeking to cater each article can be found in tables B.1 and B.2 of Appendix B. to risk-averse investors. These elements of trust lessen the A positive (negative) sign in the second column indicates that risks perceived by those buying and selling securities. There an increase in the level of the variable leads to an increase exists robust evidence that backs this positive link between (decrease) in liquidity. banking depth and capital market liquidity, although the research has focused on equity markets. 31. According to the Bank for International Settlements (BIS) (2017, 4), “A repurchase agreement (repo) is an agreement to sell securities…coupled with an agreement to repurchase these securities at a pre-specified price at a later date. A reverse repo is the same set of transactions seen from the perspective of the party lending cash and receiving the securities as collateral. A repo is economically similar to a collateralised loan since the securities provide credit protection in the event that the seller (i.e., the cash borrower) is unable to complete the second leg of the transaction.” 32. Huh and Infante (2021), BIS (2017), and Fritsche, Grill, and Lambert (2020) explain why the repo market can increase capital market liquidity. 33. In general, the less sophisticated investors do not massively participate in derivatives markets. 34. Running counter to this hedging argument, because risk does not disappear but is redistributed, derivatives may be destabilizing when used for speculative goals. Derivatives are a leveraged substitute to trading the underlying asset and therefore may bring about volatile payoffs. However, this does not discredit the claim that, for the typical risk-averse investor, derivatives improve the risk exposure and so work in favor of more-liquid securities markets. 35. Beber and Pérignon (2013), Acharya et al. (2009), Narasimhan and Kalra (2014), the Organisation for Economic Co-operation and Development (OECD) (2007), and Peterhoff et al. (2016), among others, offer sound arguments, but not hard evidence, in favor of the liquidity-enhancing role of derivatives. Looking at the reverse causality, from the underlying asset liquidity to the development of a derivatives market, the situation is similar, with a clear conceptual consensus but little empirical evidence. One exception in the latter case is the work of Gang (2016). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 19 >>> Table 3.2 Drivers of Capital Markets Liquidity: Theoretical and Empirical Signs Category Variable Theoretical Empirical Stock +/− NA Asset class Corporate bonds +/− NA Government bonds +/− NA Profitability + + General Asset tangibility + + Issuer characteristics Size + + Leverage +/− + For equity issuers Governance and transparency + + Ownership concentration − − Credit risk +/− − For bond issuers Maturity and age − − Issuance size + + Institutional investors +/− + Retail investors +/− + Foreign investors +/− + Market participants High-frequency traders +/− + Market makers + + Analyst coverage + + Capital markets volatility +/− − Structure and functioning of the capital Internationalization +/− + markets Analyst coverage + + GDP growth and level + + Preconditions for capital markets Macroeconomic instability +/− − Macroeconomic environment Fiscal deficits and debt +/− + development Expansionary monetary policy + + Legal investor protection + + Institutional environment Rule of law and political risk + + Banking system development + + Financial market structure Repo market development + NA and stability Derivatives market development + NA Note: The signs in the Empirical column correspond to the positive or negative correlation—if statistically significant—found in the majority (not necessarily all) of the econometric studies reviewed. NA = no evidence available regarding the relative effect of the asset class (stocks, corporate bonds, and government bonds) on liquidity. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 20 >>> Section 4. Liquidity Effects: Survey Of The Empirical Literature Overall, the economic literature identifies expected returns as the key variable that is directly affected by the degree of liquidity of individual corporate securities, on the premise that poor liquidity impedes efficient pricing and undermines investors’ ability to materialize potential gains quickly and at low cost. Investors seek compensation by requiring a higher return for bearing the costs of illiquidity. This liquidity premium inflates expected stock returns and (both government and corporate) bond yield spreads. In addition, in the context of stocks, the economic literature has dealt with two additional variables, leverage and external cost of issuance. Leverage. Because of the existence of a liquidity premium, equity financing for firms with illiquid stocks becomes more expensive and, thus, all else being equal, less attractive than debt financing, leading to higher leverage.36 Cost of external equity issuance. The more liquid the market is for the underlying stock, the easier it is for underwriters to place a new issue for the same company and reduce the associated fees. All three effects of liquidity have empirical support. The full list of papers supporting the empirical signs and the key findings of each article can be found in tables B3 and B4 of Appendix B. It must be mentioned that there is also econometric evidence uncovering a positive link between liquidity (as measured by value traded to GDP and turnover) and GDP.37 However, note that liquidity by itself has only an indirect impact on aggregate outcomes, because liquidity becomes valuable only when the dynamism of secondary markets helps mobilize resources toward investment and technological innovations via fresh funds raised in primary capital markets. 36. The argument also applies partially to corporate bonds because liquidity is valuable for bond investors as well. However, because bonds have a predetermined maturity and stocks do not, liquidity is a much more coveted feature in the latter case. At any rate, the longer the bond maturity, the more appealing liquidity becomes. 37. See Carvajal et al. (2019). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 21 >>> Section 5. Conclusions This note involved searching several hundred studies and reviewing in detail the 123 high- quality empirical contributions on the drivers and effects of stock and corporate bond liquidity that were identified. They cover advanced economies and emerging markets and developing economies over the past three decades. The key conclusion from this review is that liquidity has tangible, significant benefits for corporates, as it reduces the overall cost of financing. The empirical research also points to the benefits of liquidity in promoting greater use of equity and lower leverage. At a country level, liquidity (measured as value traded to GDP and turnover) has been linked to economic growth. As these benefits are documented, the main question is how to promote liquidity. The economic literature and the empirical research offer valuable insights for policy makers into what can and cannot be done to foster liquidity. First, the overall objective of enhancing liquidity should be to attract the entry of a large number of new investors and issuers, so as to strengthen the issuance of new private sector securities and hence support a faster and stable GDP growth rate.38 Second, there are no “bullet-proof” aggregate tools to address a low level of liquidity in a market. At the end of the day, liquidity will be a result of the presence of both a wide range of investors and a broad set of companies with “solid fundamentals,” which in turn are affected by the structure and functioning of the capital markets, the macroeconomic and institutional environments, and the level of development of the financial sector, since they all hinge on the risk-return appetite of investors on the one hand and the appetite and need for companies to raise funding in the capital markets on the other.39 Within this context, a few additional insights should be highlighted. First, the active debate among policy makers about the role in the market of particular investor groups (for example, foreign investors and, more recently, high-frequency traders) must be 38. The mostly short-lived stock market boom in several emerging economies in the 1990s is a useful reminder that burgeoning stock valuations and trading volumes are not sufficient conditions for a vibrant primary bond and stock market, where corporates are willing and able to raise fresh funds in capital markets. As claimed later in this section, many factors pertaining to the macro, legal, financial, and corporate areas must align beforehand for that to happen. 39. This argument highlights the interaction between primary (issuance) and secondary (trading) markets. For a healthy and substantial increase in liquidity, both investors and issuers (both old and new) need incentives to participate. For the latter, the most powerful incentive to list and improve internal governance practices is the need to raise capital. As a result, profound changes in liquidity are ultimately linked to the dynamics of corporate financing. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 22 acknowledged. As previously stated, the empirical research conducive to a more liquid market. However, market makers displays a strong consensus (yet not unanimity, as usual in do not hold the key to the creation of liquidity in emerging empirical science) that the participation of all these types of markets per se, as their business hinges on conditions that investors benefits market efficiency in general and liquidity in are similar to those behind the willingness of all investors particular. However, this finding in no way detracts from or is to trade. Above all, market makers are faced with two kinds inconsistent with the notion that financial regulators should of risks: namely, adverse selection risk (the potential losses have in place robust monitoring arrangements and a robust from trading with someone having superior information) policy tool kit to allow them to deal with potential problems and inventory risk (the potential losses from unanticipated in the market as they arise. For such problems, it should be changes in the price of the securities the market maker holds). realized that capital markets are inherently unstable, as the These risks intensify in countries characterized by high macro, very activity of trading hinges on both rational and irrational financial, and institutional volatility, discouraging the arrival of expectations that are hard to anticipate and quite sensitive to market makers or causing bid-ask spreads to skyrocket. This corporate and aggregate news that is constantly bombarding finding suggests that market makers are unlikely to break into the market. Under these circumstances, it is conceivable that the market before such conditions are met and a threshold of liquidity may endure sudden and violent swings associated market liquidity has already been reached. with periods of market uncertainty and crisis. However, the present review suggests that these illiquidity phases should By the same token, while acknowledging that empirical not be attributed to the systematic behavior of any specific research is not available, experience indicates that other group(s) of investors. Instead, the root cause should be aspects of the financial sector, such as well-functioning repo sought in a combination of macro and financial imbalances markets, are bound to play a relevant role in enhancing with erratic mood changes in investor behavior at large. liquidity. However, to work properly, repo markets need to be anchored in securities that meet certain minimum Regarding companies, the empirical research is consistent requirements, which are essentially those that the empirical in that certain characteristics of the issuer matter for liquidity. research has associated with the drivers of liquidity. Similarly, A key factor is size (of companies for equity and of the bond derivatives markets require that a minimum level of liquidity issuance for bonds), which suggests the need for policy already exist in the underlying assets. makers to have realistic expectations about the potential to increase liquidity for small companies and small issuances. Finally, although the research has focused mainly on stocks, Note that digitization, in particular the fractionalization of the macroeconomic environment and institutional environment securities, might have a (positive) impact on liquidity, but for are bound to affect liquidity, inasmuch as they feed into the small companies and small issuances it is likely that such an expectations of investors and companies alike. effect would be in the margins (that is, in small quantities). In addition, the results of the empirical research strongly This all leads to the conclusion that there are no easy and indicate that other traits also matter, including corporate instant solutions to increase capital market liquidity. However, governance and low ownership concentration for equity progress can be made from a multidimensional approach issuers on the one hand and credit risk, age, and maturity combining the macroeconomic, financial, and institutional for bond issuers on the other hand. Thus, any policy aiming factors discussed here. to enhance liquidity in these markets should take these characteristics into consideration. The findings of the research indicate that other aspects of the capital markets also matter. For example, research has found that a more widespread and active presence of market makers, especially in scarcely traded securities, may be EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 23 >>> Appendix A: Analysis Of Key Liquidity Indicators Used In The Literature Because of the multifaceted nature of liquidity, both quantity-based and price-based liquidity measures have been constructed (Hameed et al. 2019). The quantity-based measures are intended to gauge the intensity of trading, whereas the price-based indicators are meant to capture the price impact of such trading activity. Regarding quantity-based metrics, a distinction is made between trading volume and trading frequency indicators. The former looks into the monetary amounts being exchanged in the market (with turnover as an extensively employed measure), whereas the latter focuses on the number of transactions taking place over a given period (such as the proportion of days in which the security is traded). In turn, the price-based indicators can be classified into the return-based and the transaction cost–based approaches. The first group hinges on the premise that, for a perfectly liquid asset, the return should be unaffected by the volume of transactions. Also, in the absence of new valuation-altering information, more-liquid securities should display less volatile returns. The second group concerns only dealer markets, where a bid-and-ask quote exists, and exploits the size of the bid-ask spread as a measure of transaction costs. For clarity purposes, this note focuses on the leading and most frequently used measures developed over the past decades.40 Quantity-based indicators A key basic indicator that can be found in the literature is trading volume, which comprises the total value (quantity times price) of the securities being sold and bought during a specified period, or: Trading volume = where is the trading price and is is the traded quantity for trade i (i = 1, …, n) at time t. This figure is a monetary value and thus can provide a biased picture of liquidity. For instance, in a bull market, volumes would grow, but that would not indicate any improvement in liquidity. Similar considerations would call into question any comparison across securities and countries. For this reason, trading volumes are typically scaled by the outstanding values to produce a turnover ratio, that is, the number of times an asset changes hands during a given period: 40. A number of additional measures have been derived by other scholars on the basis of the metrics presented in the main text, but they are not described separately; most of them have a more limited application and in fact constitute minor variations of the variables presented in the main text. Similarly, we are not going into the operational issues related to the cleaning and aggregation across multiple transactions as a preliminary step to come up with market-level liquidity indicators. Useful surveys of alternative liquidity measures include those of Sarr and Lybek (2002); Holden, Jacobsen, and Subrahmanyam (2014); Gabrielsen, Marzo, and Zagaglia (2011); and Ametefe, Devaney, and Marcato (2016). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 24 Turnover ratio = Where is the number of outstanding securities and is the average price across n (i = 1, …, n) trades at time t. Although these statistics have a very intuitive interpretation and the required data are widely available, they do not tell the whole liquidity story either. High volumes and turnover ratios may result from a few large and sporadic transactions, which appears to be inconsistent with the notion of a liquid market in which many and frequent trades of all sizes happen on a regular basis. To deal with this limitation, a simple measure proposed in the literature is the number of zero trading days within a particular interval. As price data are usually more readily available than volumes and the lack of trading should be strongly correlated with the lack of security price movements, the proportion of zero-return days is commonly employed in empirical studies: Zero-return days = where N is the number of days with zero returns and T is the number of total trading days in a period (say, a month). Price-based indicators The bid-ask spread is the most direct measure of transaction costs. It equals the difference between the lowest price at which a dealer is willing to sell (ask) and the highest price at which the dealer is willing to buy (bid). It thus represents the trading cost (profit) for the buyer (seller) for a hypothetical, simultaneous, round-trip trade. As the absolute quoted spread, measured in units of currency, may blur any meaningful comparison within and between securities and countries, it is customary to use the relative or percent quoted spread, obtained from dividing the absolute spread by the midpoint between the two prices. More formally: (Relative) Bid-ask quoted spread = where = lowest ask price at time = highest bid price at time t, and =( + )/2 = mid-quote price. Because trades sometimes occur outside the previous bid-ask range, an effective spread can be calculated thus: (Relative) Bid-ask effective spread = where is the absolute value of the difference between the actual trade price and the mid-quote price. Because the mid-quote price can be viewed as a benchmark for the frictionless price, the above deviation can be interpreted as the one-way trading cost; multiplying it by 2 transforms it into a round-trip equivalent cost. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 25 Although the bid-ask spread is the most used measure of trading costs, it faces three potential shortcomings. First, it cannot be computed except for dealer markets and where the granular transaction level is publicly available; second, the spread does not say much about how prices are affected by the level of transactions; and finally, it does not capture the volume dimension of liquidity. As an extreme example, if only a single transaction takes place, but it does so at zero spread, it could lead to the conclusion that perfect liquidity prevails. Roll (1984) developed an implicit bid-ask spread measure based on the serial covariance of security prices. Assuming that the market is informationally efficient and that buy and sell orders have the same probability, the (negative) covariance of price variations would be a measure of illiquidity. Because prices move up or down only as a result of whether transactions take place at the bid or the ask quote (price changes due to the arrival of new information are ruled out), a negative covariance structure emerges, which would be zero under no spread. Formally: Roll = where stands for covariance and and is the price change at time t and t-1, respectively. This measure is quite popular as it requires only security price series, but it still relies on a few assumptions that may or may not hold all the time. The difficulty in interpreting positive covariances adds to the limitations of this approach: because only negative covariances proxy for illiquidity, positive covariances are usually replaced by zeros. Last but not least, the Amihud (2002) indicator looks to measure the price impact of trading volumes. In perfect markets, with no new information affecting market valuations, the volume of trade should cause no price changes in either direction. With this premise in mind, the following formulation is advanced: Amihud = where is the absolute value of the security return at time t. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 26 >>> Appendix B: Summary Findings from Papers on Liquidity >>> Table B.1 Liquidity Drivers: Empirical Signs Variable Empirical sign Studies Bond issuance size Positive Hotchkiss, Warga, and Jostova (2002); Bao, Pan, and Wang (2011); Gündüz et al. (2023); European Commission (2017); Galliani et al. (2014); Hameed, Helwege, Li, and Packer (2019); Javid and Khan (2019) Bond age Negative Fecht, Füss, and Rindler (2014); O’Hara and Zhou (2020); Hotchkiss, Warga, and Jostova (2002); Bao, Pan, and Wang (2011); Gündüz et al. (2023); European Commission (2017); Hameed, Helwege, Li, and Packer (2019) Bond maturity Negative O’Hara and Zhou (2020); Bao, Pan, and Wang (2011); Bonner, Brouwer, and van Lelyveld (2018); Gündüz et al. (2023); Galliani et al. (2014); Biais et al. (2006); Hameed, Helwege, Li, and Packer (2019) Credit risk Negative Fecht, Füss, and Rindler (2014); Hotchkiss, Warga, and Jostova (2002); Bonner, Brouwer, and van Lelyveld (2018); Gündüz et al. (2023); Galliani et al. (2014); Biais et al. (2006); Javid and Khan (2019) Corporate Positive Chung, Elder, and Kim (2010); Fecht, Füss, and Rindler (2014); Hotchkiss, governance and Warga, and Jostova (2002); Ali, Liu, and Su (2016); Brandao-Marques (2016); transparency Moshirian et al. (2017); Prommin, Jumreornvong, and Jiraporn (2014); Foo and Zain (2010) Market volatility Negative Anderson and Stulz (2017); Rösch and Kaserer (2014); Anand and Venkataraman (2016); Brandao-Marques (2016); European Commission (2017); Karolyi, Lee, and Van Dijk (2012); Lee, Sapriza, and Wu (2016); Chen and Poon (2008); Moshirian et al. (2017); Agudelo Rueda (2010); Pino Izquierdo (2017); Ding, Ni, and Zhong (2016) Internationalization Positive Ng et al. (2016); Levine and Schmukler (2006); Dang et al. (2015); Hales and Mollick (2014); Correia and Amaral (2014); Chipunza and McCullough (2018); Ding, Ni, and Zhong (2016) Foreign traders Positive Ng et al. (2016); Vagias and Van Dijk (2011); Karolyi, Lee, and Van Dijk (2012); Benítez Gárate (2016); Peranginangin et al. (2016); Kapingura and Ikhide (2015) Retail investors Positive Wang and Zhang (2015); Abudy (2020); Barrot, Kaniel, and Sraer (2016); Ekkayokkaya, Jirajaroenying, and Wolff (2020); Ozik, Sadka, and Shen (2021); Peress and Schmidt (2016); Nguyen et al. (2020); Arouri et al. (2013) Institutional investors Positive Blume and Keim (2012); Rubin (2007); Opricǎ and Weistroffer (2019); Karolyi, Lee, and Van Dijk (2012); Brandao-Marques (2016); Cueto (2009); Ajina, Lakhal, and Sougné (2015); Liu (2013) High-frequency Positive SEC (2020); Ersan et al. (2020); Hendershott et al. (2011); Brogaard et al. trading (2015); Hendershott and Riordan (2013); Brogaard et al. (2018) EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 27 Table B.1 Liquidity Drivers: Empirical Signs (cont.) Variable Empirical sign Studies Ownership Negative Wang and Zhang (2015); El-Nader (2018); Al-Jaifi (2017); Ding, Ni, and Zhong concentration (2016); Ginglinger and Hamon (2007); Rösch (2012) Expansionary Positive Christensen and Gillan (2022); Grimaldi, Crosta, and Zhang (2021); Bonner, monetary policy Brouwer, and van Lelyveld (2018); Chordia, Sarkar, and Subrahmanyam (2001) Stock return volatility Negative Rösch (2012); Ding, Ni, and Zhong (2016); Frieder and Martell (2006); El-Nader (2018); Al-Jaifi (2017); Gopalan, Kadan, and Pevzner (2012) Size Positive Wang and Zhang (2015); El-Nader (2018); Al-Jaifi (2017); Ding, Ni, and Zhong (2016); Frieder and Martell (2006); Gopalan, Kadan, and Pevzner (2012) Profitability Positive Ding, Ni, and Zhong (2016); Wang and Zhang (2015); El-Nader (2018); Al-Jaifi (2017); Gopalan, Kadan, and Pevzner (2012) Leverage Positive El-Nader (2018); Al-Jaifi (2017); Frieder and Martell (2006) Asset tangibility Positive Al-Jaifi (2017); El-Nader (2018); Ding, Ni, and Zhong (2016) Market makers Positive O’Hara and Zhou (2020); Aitken et al. (2007); Nimalendran and Petrella (2003); Jain (2003); Charitou and Panayides (2009) Analyst coverage Positive Dang et al. (2015); de Franco, Vasvari, and Wittenberg-Moerman (2009); Irvine (2003); Staglianò, La Rocca, and Gerace (2018) Note: The empirical signs correspond to positive or negative correlation—if statistically significant—found in the majority (not necessarily all) of the studies, as cited in the last column. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 28 >>> Table B.2 Liquidity Drivers: Literature Survey Author(s) Country Liquidity Explanatory (year of or region Period Asset class Main result measure(s) variable(s) publication) sampled SEC (2017) United 1996– Corporate Trading Regulatory Insignificant effect for States 2016 bonds volume changes Treasury bonds and positive Turnover (Volcker Rule for corporate bonds from Government Quoted bid- and Basel III) regulatory changes. bonds ask spread Effective bid- ask spread Roll Chordia, United 1991–98 Equity Trading Returns and Lower return and liquidity Sarkar, and States Corporate volume liquidity in other in one asset class (that is, Subrahmanyam bonds Quoted bid- asset classes stock) reduces liquidity in (2001) ask spread Monetary policy other asset classes (that is, Government Effective bid- bonds). bonds ask spread Expansionary monetary policy increases liquidity. Chung, Elder, United 2003–07 Stocks Quoted bid- Corporate Good corporate governance and Kim (2010) States ask spread governance increases liquidity. Effective bid- quality ask spread Fecht, Füss, United 2004–12 Corporate Roll Transparency Transparency enhances and Rindler States bonds Amihud of company liquidity, and this effect (2014) information increases during financial Bond age distress periods. Credit risk Anderson and United 2004–14 Corporate Turnover 2008 crisis Quantity-based liquidity Stulz (2017) States bonds Zero return measures went down after days the crisis, but price-based Effective bid- measures improved. ask spread After 2008, liquidity drops Amihud only after extreme systemic volatility, but not less extreme episodes. Goyenko and United 1962– Stocks Quoted bid- Stock liquidity Stock and government Ukhov (2009) States 2003 Government ask spread Treasury bond bond liquidities move with bonds Amihud liquidity each other, and each has predictive power for the other. O’Hara and United February Corporate Amihud Market maker In addition to the negative Zhou (2020) States 2020 bonds activity effect of bond age and time to May Fed support to to maturity, liquidity improves 2020 market makers with market-making activity Bond age and with Fed support of Time to maturity market makers, acting as a “market maker of last resort.” EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 29 Table B.2 Liquidity Drivers: Literature Survey (cont.) Author(s) Country Liquidity Explanatory (year of or region Period Asset class Main result measure(s) variable(s) publication) sampled Hotchkiss, United 1995–99 Corporate Trading Listed equity Firms with actively listed Warga, States bonds volume Actively listed stock have more liquidity. and Jostova equity Newer and larger bonds (2002) Credit risk are more liquid. Credit risk Issuance size increases the liquidity of Bond age investment-grade bonds and reduces that of high-yield (low-grade) bonds. Stock and corporate markets’ liquidities are positively correlated. Blume and United 1982– Stocks Amihud Institutional Higher institutional investor Keim (2012) States 2010 investor holdings increase liquidity. holdings Rubin (2007) United 1999– Stocks Trading Institutional Liquidity is positively related States 2003 volume investor to total institutional holdings Quoted bid- holdings but negatively related to ask spread institutional blockholdings. Bao, Pan, and United 2003–09 Corporate Roll Bond age Liquidity decreases with bond Wang (2011) States bonds Maturity age, time to maturity, and Issuance size smaller issuance sizes. Rösch and Germany 2003–09 Stocks Quoted bid- Financial crisis Liquidity commonality peaks Kaserer (2014) ask spread at crisis times, accompanied by flight-to-liquidity and flight to quality. Anand and Canada 2006 Stocks Quoted bid- Market volatility Higher stock market volatility Venkataraman ask spread increases liquidity supply (2016) by market makers, but they enter and exit in unison, thus creating some market fragility. Ivanov, Orlov, United 2011–16 Corporate Trading Dealer Ambiguous effect of dealer and Schihl States and bonds volume inventories inventories on liquidity. (2020) United Turnover Kingdom Zero return days Amihud Ali, Liu, and Su Australia 2001–08 Stocks Quoted bid- Firm size Liquidity increases with firm (2016) ask spread Leverage size, leverage, and corporate Profit volatility governance quality and Corporate decreases with profit volatility. governance quality EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 30 Table B.2 Liquidity Drivers: Literature Survey (cont.) Author(s) Country Liquidity Explanatory (year of or region Period Asset class Main result measure(s) variable(s) publication) sampled Bonner, Netherlands 2014–16 Corporate Turnover Maturity Liquidity decreases with Brouwer, and bonds Roll Credit risk maturity and credit risk and van Lelyveld Government Amihud rises with bank regulations (2018) bonds (Basel III) favoring the bank demand for some bonds. Unconventional monetary policy supports liquidity in stress times. Gündüz et al. Germany 2008–14 Corporate Effective bid- Issuance size Liquidity goes up with (2023) and United bonds ask spread Bond age issuance size and goes States Roll Time to maturity down with bond age, time Individual to maturity, and credit risk trading volume (rating). Moreover, although Credit risk the US has more trading activity than Germany, lack of post-trade transparency in Germany (no TRACE-like platform) crowds trading in a few more actively traded bonds. Brandao- Chile 1993– Stocks Amihud Lagged liquidity Liquidity has a strong inertial Marques (2016) 2015 VIX component, and it responds US policy rate to foreign conditions: Domestic higher international rates macroeconomic and volatility drain liquidity. factors Domestic macro factors do not seem to have an influence. Opricǎ and eurozone 2013–16 Corporate Quoted bid- Institutional Greater institutional investor Weistroffer bonds ask spread investor holdings increase liquidity but (2019) Effective bid- holdings also return volatility. ask spread Ng et al. (2016) 39 2003–07 Stocks Zero return Foreign Liquidity increases with developed days portfolio foreign portfolio ownership, and Effective bid- ownership ADR issuance, and MSCI emerging ask spread ADR issuance membership. countries Amihud MSCI membership Będowska- Hungary, 2008–17 Stocks Quoted bid- Liquidity in Commonality across national Sójka Czech ask spread stock markets stock market indexes. and Echaust Republic, Amihud in other (2019) Poland, countries Russian Federation, and Türkiye EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 31 Table B.2 Liquidity Drivers: Literature Survey (cont.) Author(s) Country Liquidity Explanatory (year of or region Period Asset class Main result measure(s) variable(s) publication) sampled European 27 2011–14 Corporate Turnover Bond age Liquidity decreases with bond Commission developed bonds Zero return Issuance size age, issuance size, and the (2017) and days Individual bond’s return volatility. emerging Quoted bid- volatility European ask spread markets Vagias and Van 46 1995– Stocks Amihud Portfolio capital Foreign capital flows enhance Dijk (2011) developed 2008 flows local liquidity. and EMDE countries Galliani et al. 27 2005–12 Corporate Trading Issuance size Liquidity increases with (2014) developed bonds volume Duration issuance size and decreases and Zero return Credit risk with the bond’s duration and emerging Government days Market liquidity credit risk. Individual bond European bonds Quoted bid- liquidity is correlated with markets ask spread market liquidity, especially Roll when markets are under Amihud stress. Karolyi, Lee, 40 1995– Stocks Amihud Market volatility Liquidity commonality is and Van Dijk developed 2009 Foreign higher in emerging versus (2012) and investors developed countries and emerging Institutional increases with market markets investor trading volatility, the presence of Emerging foreign investors, and the country correlated trading behavior of institutional investors. Levine and 45 1989– Stocks Turnover Cross-listing, Internationalization reduces Schmukler emerging 2000 Zero return ADR issuance, domestic liquidity of the firm (2006) markets days and issuance and the domestic market as abroad a whole. Dang et al. 39 1996– Stocks Quoted bid- Cross-listing For cross-listed stocks, (2015) developed 2007 ask spread commonality with domestic and market decreases but emerging commonality with host market markets increases. Biais et al. Developed 2003–05 Corporate Quoted bid- Maturity Liquidity decreases with (2006) and bonds ask spread Credit risk maturity, credit risk, and emerging Transaction transaction size. European size markets EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 32 Table B.2 Liquidity Drivers: Literature Survey (cont.) Author(s) Country Liquidity Explanatory (year of or region Period Asset class Main result measure(s) variable(s) publication) sampled Brandao- 23 2003–14 Stocks Amihud GDP growth Economic growth, minority Marques (2016) emerging Protection shareholder protection, and markets of minority higher institutional investor shareholders ownership enhance liquidity. Institutional investor ownership Benítez Gárate 39 1995– Stocks Turnover Capital controls Capital controls reduce (2016) developed 2009 Amihud domestic market liquidity. and emerging countries Lee, Sapriza, 40 1990– Stocks Amihud Sovereign Increases in the sovereign and Wu (2016) developed 2009 spreads spreads reduce liquidity, with and downgrades having a greater emerging effect than upgrades. countries Chen and Poon 37 1996– Stocks Amihud Stock Stock market and (2008) developed 2002 market and macroeconomic volatility and macroeconomic reduces stock market emerging volatility liquidity, and the effect is countries Stock market persistent. Stock market return returns increase liquidity, Regional and whereas regional and US US stock stock market liquidity is liquidity positively correlated with domestic stock liquidity. Moshirian et al. 39 1996– Stocks Quoted bid- GDP growth More volatile GDP growth (2017) developed 2010 ask spread volatility and lower investor protection and Investor increase commonality. emerging protection countries Hales and Argentina, 2003–10 Stocks Trading ADR issuance ADR issuance enhances Mollick (2014) Brazil, volume domestic stock liquidity. Chile, and Turnover Mexico Cueto (2009) Chile and 2006 Stocks Quoted bid- Institutional Blockholding reduces stock Brazil ask spread investors and liquidity. Effective bid- other stock ask spread blockholders Christensen, Mexico 2007–17 Government Estimated Foreign investor Liquidity premium increases Fischer, and bonds liquidity holdings with foreign investor Shultz (2019) premium participation. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 33 Table B.2 Liquidity Drivers: Literature Survey (cont.) Author(s) Country Liquidity Explanatory (year of or region Period Asset class Main result measure(s) variable(s) publication) sampled Correia and Brazil 1995– Stocks Quoted bid- % of capital Free float and ADR issuance Amaral (2014) 2010 ask spread of top 3 improve liquidity. Effective bid- shareholders ask spread ADR issuance Agudelo Rueda Colombia 2001–07 Stocks Quoted bid- Stock market Market volatility reduces (2010) ask spread volatility liquidity. Pino Izquierdo Peru 2006–15 Stocks Quoted bid- Stock market Stock market return is (2017) ask spread return positively correlated and Stock market its volatility is negatively return volatility correlated with liquidity. Chabchitrchaidol Thailand 1999– Government Quoted bid- Yield volatility Yield volatility increases and and Panyanukul 2004 bonds ask spread Trading volume trading volume decreases (2008) liquidity. Prommin, Thailand 2006–09 Stocks Turnover Corporate Good corporate governance Jumreornvong, Amihud governance increases liquidity. and Jiraporn quality (2014) Hameed, Malaysia 1997– Corporate Turnover Issuance size There is no clear conclusion, Helwege, 2017 bonds Zero return Bond age as the effect of these Li, and Packer days Time to maturity variables varies across (2019) Quoted bid- liquidity measures in ask spread both sign and statistical Effective bid- significance. ask spread Amihud Foo and Zain Malaysia 2007 Stocks Turnover Board Board independence (2010) Zero return independence increases liquidity. days Quoted bid- ask spread Peranginangin Indonesia 2008–10 Stocks Quoted bid- Foreign investor Foreign investor participation et al. (2016) ask spread participation increases domestic liquidity commonality. Javid and Khan Pakistan 2019 Corporate Trading Credit risk Liquidity increases with (2019) bonds volume Issuance size issuance size, bond return Bond return volatility, and the stock volatility market return and decreases Stock market with credit risk. return Chipunza and South Africa 1990– Stocks Trading Cross-listing Internationalization increases McCullough 2014 volume and ADR domestic liquidity of the firm (2018) Turnover issuance only temporarily to later revert to previous levels. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 34 Table B.2 Liquidity Drivers: Literature Survey (cont.) Author(s) Country Liquidity Explanatory (year of or region Period Asset class Main result measure(s) variable(s) publication) sampled Kapingura and South Africa 1995– Government Trading Macroeconomic Macroeconomic instability Ikhide (2015) 2009 bonds volume instability reduces and foreign investor Turnover Foreign investor participation increases Quoted bid- participation liquidity. ask spread Hendershott, United 2001–05 Stocks Quoted bid– HFT HFT participation increases Jones, and States ask spread participation liquidity. Menkveld (2011) Brogaard et al. Sweden 2012 Stocks Quoted bid- HFT HFT participation increases (2015) ask spread participation liquidity. Hendershott Germany 2008 Stocks Quoted bid- HFT HFT participation increases and Riordan ask spread participation liquidity. (2013) Brogaard et al. United 2008–09 Stocks Quoted bid- HFT HFTs provide liquidity during (2018) States ask spread participation times of extreme price movements. El-Nader (2018) United 2002–16 Stocks Amihud Free float Greater free float increases Kingdom Turnover Institutional liquidity. ownership Greater institutional Stock price ownership reduces liquidity. Firm size Issuers that are larger, more Firm leverage leveraged, and have more Firm’s asset tangible assets have more tangibility liquid stock. The higher the stock price, the more liquid the stock. Wang and United 2004–11 Stocks Amihud Retail Retail ownership increases Zhang (2015) States ownership liquidity, especially in small- Institutional cap stocks. ownership Greater institutional Firm size ownership enhances liquidity. Idiosyncratic Larger firms are more liquid. volatility Firm’s stock return volatility diminishes liquidity. Al-Jaifi (2017) Malaysia 2009–12 Stocks Amihud Free float Greater free float increases Stock price liquidity. Firm size Issuers that are larger, more Firm profitability profitable, more leveraged, Firm leverage and have more tangible Firm’s asset assets have more liquid tangibility stock. Idiosyncratic The higher the stock price, volatility the more liquid the stock. Firm’s stock return volatility diminishes liquidity. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 35 Table B.2 Liquidity Drivers: Literature Survey (cont.) Author(s) Country Liquidity Explanatory (year of or region Period Asset class Main result measure(s) variable(s) publication) sampled Lee (2011) Singapore 2013 Stocks Quoted bid- Stock price The higher the stock price, ask spread the more liquid the stock. Chordia, United 1991–98 Stocks Quoted bid- Monetary policy Expansionary monetary Sarkar, and States ask spread policy improves liquidity Subrahmanyam Trading in crisis times but has no (2001) volume significant effect in normal times. Ding, Ni, and 55 2003–11 Stocks Amihud Free float Greater free float increases Zhong (2016) emerging Stock price liquidity. and Firm size Issuers that are larger, developed Firm profitability more profitable, and more countries Firm leverage leveraged and have more Firm’s asset tangible assets have more tangibility liquid stock. Idiosyncratic The higher the stock price, volatility the more liquid the stock. Financial crisis Firm’s stock return volatility ADR issuance diminishes liquidity. Financial crises dry up liquidity. ADR issuance increases local liquidity. Ginglinger and France 1998– Stocks Quoted bid- Block Block ownership (and thus Hamon (2007) 2003 ask spread ownership less free float) reduces stock liquidity. Rösch (2012) Germany 2003–08 Stocks Amihud Free float Greater free float increases Stock price liquidity. Idiosyncratic The higher the stock price, volatility the more liquid the stock. Firm’s stock return volatility diminishes liquidity. Frieder and United 1988–98 Stocks Quoted bid- Firm size Larger and more leveraged Martell (2006) States ask spread Firm leverage firms, with lower volatility Effective bid- Idiosyncratic of returns, display higher ask spread volatility liquidity. Gopalan, United 1962– Stocks Amihud Firm size Issuers that are larger and Kadan, States 2005 Roll Firm profitability more profitable have more and Pevzner Idiosyncratic liquid stock. (2012) volatility Firm’s stock return volatility diminishes liquidity. Christensen and United 2010–11 Government Quoted bid- Quantitative Unconventional monetary Gillan (2022) States bonds ask spread easing policy reduces bid-ask spreads of securities targeted by the program. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 36 Table B.2 Liquidity Drivers: Literature Survey (cont.) Author(s) Country Liquidity Explanatory (year of or region Period Asset class Main result measure(s) variable(s) publication) sampled Grimaldi, United 2010–11 Government Amihud Quantitative Unconventional monetary Crosta, States bonds Trading easing policy reduces, up to a point, and Zhang volume bid-ask spreads of securities (2021) Turnover targeted by the program. Bonner, Netherlands 2014–16 Government Amihud Quantitative Unconventional monetary Brouwer, and corporate Trading easing policy reduces, during volatile and van bonds volume times, bid-ask spreads of Lelyveld (2018) securities targeted by the program. Aitken et al. France 2006–07 Stock Quoted bid- Market maker Market makers reduce (2007) ask spread activity for spreads, except for quoted Effective bid- thickly traded spreads ask spread stocks. Realized bid- ask spread Nimalendran Italy 1997–98 Stocks Quoted bid- Market maker Market makers reduce and Petrella ask spread activity spreads and increase trading (2003) volume, especially for thinly traded stocks. Jain (2003) 51 2000 Stocks Quoted bid- Market maker Market makers reduce developed ask spread activity spreads. and Effective bid- emerging ask spread countries Realized bid- ask spread Abudy (2020) Israel 2012–14 Stocks Quoted bid- Retail investors A larger proportion of retail ask spread investors increases liquidity. Amihud Barrot, Kaniel, France 2002–12 Stocks Retail Retail investors A larger proportion of retail and Sraer imbalances investors increased liquidity (2016) during the 2008–09 crisis, Ekkayokkaya, Thailand 2003–13 Stocks Trade Retail investors Retail investors have a Jirajaroenying, execution comparative advantage and Wolff price ratio in analyzing and trading (2020) small-cap stocks. Arouri et al. France 2004–12 Stocks Turnover Retail investors Stocks with high internet (2013) search intensity experience higher liquidity in the short run, but not in the long run. Nguyen et al. Vietnam 2013–18 Stocks Trading Retail investors Stocks with high internet (2020) volume search intensity experience higher liquidity in both the short run and the long run. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 37 Table B.2 Liquidity Drivers: Literature Survey (cont.) Author(s) Country Liquidity Explanatory (year of or region Period Asset class Main result measure(s) variable(s) publication) sampled Peress and United 1980– Stocks Amihud Retail investors Retail investors contribute to Schmidt (2016) States 2007 Quoted, liquidity by serving as both realized, and noise traders and liquidity effective bid- providers. ask spreads Ozik, Sadka, United 2020 Stocks Quoted bid- Retail investors Stocks with high internet and Shen States ask spread search intensity by retail (2021) Realized bid- investors experience higher ask spread liquidity. Effective bid- ask spread Ajina, Lakhal, France 2007–09 Stocks Amihud Institutional A larger proportion of and Sougné Effective bid- investors institutional investor (2015) ask spread ownership increases liquidity. Trading volume Liu (2013) United 1980– Stocks Amihud Institutional A larger proportion of States 2007 investors institutional investor ownership increases liquidity. This holds for institutional investors in general and by type. Dang et al. 41 2000– Stocks Quoted bid- Analyst Analyst coverage is positively (2015) developed 2010 ask spread coverage correlated with stock liquidity. and EMDE Amihud countries De Franco, United 2002– Corporate Trading Analyst Analyst coverage is positively Vasvari, and States 2006 bonds volume coverage correlated with bond and Wittenberg- Stocks stock liquidity. Moerman (2009) Irvine (2003) United 1995 Stocks Trading Analyst The initiation of analyst States volume coverage coverage improves liquidity. Quoted bid- ask spread Staglianò, La Italy 2002– Stocks Quoted bid- Analyst Analyst coverage is positively Rocca, and 2007 ask spread coverage correlated with stock liquidity. Gerace (2018) Amihud EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 38 >>> Table B.3 Liquidity Effects: Empirical Signs Liquidity Effect Empirical Sign Studies Expected Negative Bao, Pan, and Wang (2010); Amihud and Meldenson (2006) ; bond and stock returns Goldstein, Hotchkiss, and Pedersen (2019); Friewald, Jankowitsch, and Subrahmanyam (2013); Amihud (2018); Harris and Amato (2016) ; Chordia, Subrahmanyam, and Tong (2014); Butt (2015), Miralles Quirós and Miralles Quirós (2006); Brandao-Marques (2016); Chiang and Zheng (2015); Houweling, Mentink, and Vorst (2005); Lee (2011), Bekaert, Harvey, and Lundblad (2007); Li, Zhang, and Li (2019); Lischewski and Voronkova (2012); Bhattacharya, Bhattacharya, and Basu (2019); Thaithanan (2011) Leverage Negative Davis, Maslar, and Roseman (2018); Lipson and Mortal (2009); Marks and Shang (2019); Nadarajah et al. (2018); Dang et al. (2019); Udomsirikul, Jumreornvong, and Jiraporn (2011) Cost of external equity Negative Hanselaar, Stulz, and Van Dijk (2019); Butler, Grullon, and Weston (2005); issuance Bundgaard and Ahm (2012); Asim, Chung, and Tian (2009) EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 39 >>> Table B.4 Liquidity Effects: Literature Survey Author(s) Country Asset Liquidity Dependent (year of or group Period Main result class measure(s) variable(s) publication) sampled Davis, Maslar, and United 2002–12 Corporate Zero return days Borrowing costs Liquidity reduces Roseman (2017) States bonds Amihud Frequency of bond borrowing costs and issuance increases issuance. Bao, Pan, and United 2003–09 Corporate Roll Yield spread Liquidity reduces Wang (2011) States bonds the yield spread. Goldstein, United 2012–17 Corporate Zero return days Yield spread Expected liquidity at Hotchkiss, and States bonds issuance reduces Pedersen (2019) the yield spread. Friewald, United 2004–08 Corporate Zero return days Yield spread There is a liquidity Jankowitsch, and States bonds Roll premium, and it Subrahmanyam Amihud increases in crisis (2013) times. Amihud (2018) United 1964–2017 Stocks Amihud Yield spread The liquidity States premium has lowered since 1998 relative to previous decades, but it remains significant. Harris and Amato United 1964–2015 Stocks Amihud Yield spread The liquidity (2016) States premium has lowered since 1998 relative to previous decades, but it remains significant. Lipson and Mortal United 1986–2006 Stocks Turnover Firm leverage Firms with more (2009) States Quoted bid-ask liquid stock use spread more equity and Effective bid-ask thus have lower spread leverage. Roll Amihud Marks and Shang United 1985–2015 Stocks Amihud Long-term debt Liquidity increases (2019) States share the share of long- term relative to short-term debt. Butler, Grullon, United 1993–2000 Stocks Trading volume Cost of raising More liquidity and Weston (2005) States Turnover equity capital reduces the cost Quoted bid-ask of raising equity, spread as measured by Effective bid-ask investment bank spread fees. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 40 Table B.4 Liquidity Effects: Literature Survey (cont.) Author(s) Country Asset Liquidity Dependent (year of or group Period Main result class measure(s) variable(s) publication) sampled Chordia, United 1976–2011 Stocks Turnover Yield spread Due to more intense Subrahmanyam, States arbitrage, increased and Tong (2014) liquidity and trading activity over the past decades is associated with attenuation of equity return anomalies. Nadarajah et al. Australia 2011–13 Stocks Quoted bid-ask Firm leverage There is a negative (2018) spread effect of corporate Amihud governance quality on leverage only for firms with highly liquid stock. Butt (2015) Finland 1994–2009 Stocks Zero return days Yield spread There is a liquidity premium. Miralles Quirós Spain 1994–2002 Stocks Amihud Yield spread There is a liquidity and Miralles premium. Quirós (2006) Brandao-Marques Chile 1993–2015 Stocks Amihud Stock returns There is a liquidity (2016) premium. Chiang and Zheng G7 1990–2009 Stocks Amihud Yield spread There is a liquidity (2015) countries premium. Houweling, Eurozone 1999–2001 Corporate Liquidity Yield spread There is a liquidity Mentink, and Vorst bonds proxies (bond premium. (2005) characteristics) Lee (2011) 50 1988–2007 Stocks Zero return days Stock returns There is a liquidity developed premium and it and increases with the emerging covariance between markets individual stock liquidity and local market liquidity. Dang et al. (2015) 41 2000–10 Stocks Effective bid-ask Firm leverage Higher stock developed spread liquidity is and Amihud associated with emerging lower leverage. markets Bekaert, Harvey, 19 1993–2003 Stocks Zero return days Expected returns Illiquidity predicts and Lundblad emerging expected returns. (2007) countries EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 41 Table B.4 Liquidity Effects: Literature Survey (cont.) Author(s) Country Asset Liquidity Dependent (year of or group Period Main result class measure(s) variable(s) publication) sampled Li, Zhang, and Li China 2006–15 Stocks Trading volume Stock returns There is a liquidity (2019) Turnover premium. Zero return days Quoted bid-ask spread Roll Amihud Lischewski and Poland 1996–2009 Stocks Zero return days Stock returns No liquidity Voronkova (2012) Roll premium is Amihud identified. Bhattacharya, India 2002–16 Stocks Trading volume Stock market Market liquidity Bhattacharya, and Turnover return positively predicts Basu (2019) Zero return days market return. Quoted bid-ask spread Udomsirikul, Thailand 2002–08 Stocks Turnover Firm leverage Firms with more Jumreornvong, Amihud liquid stock use and Jiraporn more equity and (2011) thus have lower leverage. Thaithanan (2011) Thailand 2002–08 Corporate Zero return days Yield spread There is a liquidity bonds premium. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 42 >>> Table B.5 Liquidity Trends (only descriptive): Literature Survey Author(s) Country Liquidity (year of or group Period Asset class Main result measure(s) publication) sampled Bessembinder, United States 2003–17 Corporate Trading volume Fixed-income liquidity (mostly order Spatt, and bonds Quoted bid-ask driven over the counter) lower than Venkataraman Government spread equity. (2020) bonds Government bonds more liquid than corporate bonds. Mizrach (2015) United States 2003–15 Corporate Turnover Liquidity has continued to increase bonds after the 2008 crisis, but with Stocks smaller trade sizes. Adrian et al. (2017) United States 2005–16 Corporate Trading volume Illiquidity peaked around the 2008 bonds Quoted bid-ask crisis, but afterward volumes rose Government spread and spreads went down below bonds precrisis levels. However, price impact increased and trade sizes decreased. Liang (2020) United States 2020 Corporate Quoted bid-ask Liquidity dropped in the aftermath bonds spread of the COVID-19 crisis, revealing a mismatch between liquidity demand and supply in stress events. Goyenko, Holden, United States 1993–2005 Stocks Effective bid-ask Close association between most and Trzcinka spread liquidity measures and actual (2009) Roll transaction costs (as measured by realized spread). Mallaburn, United 2012–17 Corporate Trading volume Concentration on a small number Roberts-Sklar, and Kingdom bonds of participants makes the trading Silvestri (2019) network somewhat fragile to the withdrawal of a few dealers. Cheshire (2016) Australia 1999–2015 Corporate Turnover Declining liquidity after 2008 crisis. bonds Government bonds Rakkestad, Norway 1999–2011 Corporate Trading volume Low trading activity on average and Skjeltorp, and bonds Turnover large proportion of off-exchange Ødegaard (2013) Government Quoted bid-ask (over-the-counter) activity. bonds spread Amihud Gao, Jin, and Canada 2009–15 Government Effective bid-ask Newly issued long-term Thompson (2018) bonds spread government bonds are quite illiquid Roll so they must be held in the dealers’ Amihud balance sheet for several weeks, which limits their ability to make the market for other traded bonds. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 43 Table B.5 Liquidity Trends (only descriptive): Literature Survey (cont.) Author(s) Country Liquidity (year of or group Period Asset class Main result measure(s) publication) sampled Dick-Nielsen, Denmark 2007–11 Corporate Amihud Liquidity in covered bonds has Gyntelberg, and bonds been higher than in government Sangill (2012) Government bonds, even during the 2008 crisis. bonds De Renzis, 10 developed 2006–16 Corporate Quoted bid-ask Liquidity dropped around the 2008 Guagliano, and eurozone bonds spread and 2012 crises. Expansionary Loiacono (2018) countries Government monetary policy in the postcrisis bonds spurred government bond liquidity. In both the corporate and the government segments, financial distress deteriorates liquidity. ESRB (2020) Eurozone 2007–20 Corporate Quoted bid-ask Significant decrease in liquidity bonds spread after the COVID-19 pandemic, especially in high-yield bonds. IMF (2019) United States, 2018–19 Stocks Trading volume Markets more prone to “flash crash” United Corporate episodes (sudden evaporation of Kingdom, bonds liquidity) due to less bank trading eurozone, Government and more automated trading. Japan, and bonds China Ahn, Cai, and 21 emerging 2004 Stocks Effective bid-ask Close association between most Yang (2018) countries spread liquidity measures and actual Roll transaction costs (as measured by realized spread). Lesmond (2005) 31 emerging 1991–2000 Stocks Quoted bid-ask Transaction costs are strongly countries spread correlated with the bid-ask spread. Lesmond (2005) 31 emerging 1987–2000 Stocks Trading volume Wide time and cross-country countries Turnover variation of liquidity. Preliminary Quoted bid-ask evidence of a negative correlation spread between liquidity and institutional Roll and political conditions. Amihud Yeyati, Schmukler, Argentina, 1994–2004 Stocks Trading volume Both trading volumes and costs and Van Horen Brazil, Mexico, Quoted bid-ask increase (2008) Indonesia, spread in crisis times. Republic Amihud of Korea, Thailand, and Russian Federation Carvalho and Brazil 2009–17 Corporate Zero return days The corporate bond market is Marques (2020) bonds highly illiquid: Only 1.5% of the bonds trade more than 20% of the days. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 44 Table B.5 Liquidity Trends (only descriptive): Literature Survey (cont.) Author(s) Country Liquidity (year of or group Period Asset class Main result measure(s) publication) sampled Będowska-Sójka Poland 2006–16 Stocks Amihud Low liquidity commonality. 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