As conventional wisdom has it, markets shut down during financial crises, as sellers struggle to find their buyers. However, an empirical assessment of what really goes on with secondary market liquidity in periods of financial distress is far from trivial, as a quick survey of the related literature illustrates. Whereas the relation between liquidity and market returns in the US has been studied extensively in both directions, the results differ according to the measure of liquidity in use. Moreover, much less is known about the behavior of secondary market liquidity (in its different dimensions) in periods of financial turmoil, a critical test to evaluate both the functioning of financial markets and the mechanics of financial crises. This paper contributes to fill in this gap, conducting the first systematic empirical study of secondary market liquidity under stress across emerging market crises.
A generally accepted theoretical argument relating liquidity and market returns is the collateral-based view: pronounced falls in asset prices reduce the value of financial intermediaries’ capital and increase their margin calls, forcing them to liquidate their positions, thereby inducing wider bid-ask spreads and increasing the price response to trading. Since net withdrawals are a function of the intermediaries’ performance, when the value of assets drop the short-term inflow of funds decreases or even reverses, forcing financial intermediaries to sell, adding to the price downturn, and generating a spiraling fall in some liquidity measures. Therefore, market liquidity is closely related to intermediaries’ funding needs, and this mutually reinforcing relation can generate sudden spikes in illiquidity indicators. While collateral-based theories assume that outside capital does not enter the market during downturns, fire-sale theories highlight precisely the role of outside capital: lower asset prices reward liquid outside buyers who profit from illiquid asset holders. Fire-sales (namely, forced wide-spread selling from distressed funds when investors redeem their capital en masse) put downward pressure on prices, as outside buyers demand additional compensation for providing needed liquidity.
Another strand of the literature has elaborated other models with heterogeneous investors (due, for example, to asymmetric information, heterogeneous investment opportunities, and/or government interference) that provide a possible explanation for the positive relation between trading volume and absolute changes in asset prices. If trading volume reflects disagreement between traders upon receiving new information, the greater the degree of disagreement, the larger the level of trading volume, which could explain why volume is found to be positively correlated with market volatility and with sharp price fluctuations in particular. Broner et al. (2006 and 2007) explore the role of secondary markets in helping solve problems of enforcement and repayment by redistributing assets to favored investors. They predict that turnover increases in periods of financial turbulence, when enforcement problems and default probabilities increase.
Empirically, the literature has used two types of measures as proxies of secondary market liquidity: (i) measures related to trading activity (such as volume and turnover) and (ii) measures related to trading costs (such as the price reaction to trading and bid-ask spreads).6 These two types of indicators jointly characterize what is typically called a liquid market: “a market where participants can rapidly execute large-volume transactions with a small impact on prices,” that is, at a low cost (BIS 1999).
Although they are often assumed (and shown) to be related, trading activity and trading cost capture different aspects of secondary markets and do not need to behave similarly. In tranquil times and across securities, higher volume is associated with lower transaction costs. In other words, all liquidity proxies move in the same direction. But the behavior changes in periods of financial turbulence, when shocks are of different nature. For example, a sudden increase in trading activity as investors rush to the exit might signal an increased trading demand for a given market depth, congesting the market and raising transaction costs. In fact, Chordia et al. (2001) show that bid-ask spreads and trading-activity variables respond differently during up and down markets. While trading activity variables increase both in rising and falling markets, bid-ask spreads responds asymmetrically by increasing significantly in down markets and decreasing only marginally in up markets.
In emerging markets, where crises abound, liquidity has not received much attention. One exception is Lesmond (2005), who looks at bid-ask spreads as well as several alternative measures of liquidity (turnover, and the already mentioned Amihud, Amivest, LOT, and Roll measures) for 31 emerging markets over 1987–2000. While he does not perform any econometric test, he shows a significant within-country correlation between all liquidity proxies (with the exception of turnover) and a sharp increase during the crisis period 1997:Q3 to 1998:Q3 (again, with the exception of turnover, which appears unaffected). This type of casual evidence provides the most natural motivation for a deeper econometric study of the kind presented here.
