Equity markets are different

Equity markets (specifically the market for large capitalization stocks) seem to be very different from other markets in that they are the only markets that are unconditionally liquid. The Basel Committee has officially recognized this – in their classification of 24 markets by liquidity horizons, the large cap equity market is the only market in the most liquid bucket. (Basel Committee on Banking Supervision, Fundamental review of the trading book: A revised market risk framework, Second Consultative Document, October 2013, Table 2, page 16)

There is abundant anecdotal evidence for the greater liquidity of large cap equity markets in stressed conditions – you may not like the price but you would not have any occasion to complain about the volume. For example, in India when the fraud in Satyam was revealed, the price of the stock dropped dramatically, but the market remained very liquid. In fact, the liquidity of the stock on that day was far greater than normal. During the global financial crisis, stock markets remained very liquid while liquidity in many other markets dried up. During the 2008 crisis, Societe General could unwind Kerviel’s unauthorized equity derivative position of € 50 billion in just two days.

There could be many reasons why large cap equity markets are indeed different:

• Equities trade in exchanges with pre and post trade transparency unlike many other asset classes that trade in opaque OTC markets.
• Equity markets are populated with a diverse pool of participants unlike many other markets where a single class of participants (for example, banks) dominate.
• Many participants in equity market are unregulated – individual investors and many lightly regulated investment pools.
• Equity markets are highly volatile and therefore suffer less from price stickiness. The equity market responds to a shock with a price adjustment. Most other markets have sticky prices and respond with a quantity adjustment (or quantity rationing).

At least some of these features can be replicated in other markets, and such replication should perhaps be a design goal.

Posted at 9:45 pm IST on Fri, 8 Nov 2013         permanent link

Categories: equity markets, exchanges

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