Liquidity Crises: The Functioning of Secondary Markets

As conventional wisdom has it, markets stall during financial crises, as sellers struggle to find their buyers. For example, describing the current subprime lending crisis, Paul Krugman notes “…[M]arkets in stuff that is normally traded all the time … have shut down because there are no buyers” (The New York Times, Aug. 11, 2007). Many other similar quotes can be found in major newspapers describing the LTCM, Russian, and Mexican crises, among others.

But an empirical assessment of what really goes on with secondary market liquidity in periods of financial distress is far from trivial. In a recent paper with Eduardo Levy Yeyati and Neeltje Van Horen, “Emerging Market Liquidity and Crises,” we conduct the first systematic empirical study of secondary market liquidity under stress across emerging market crises.

We find no evidence of market “paralysis” at the beginning of crises; secondary market activity does not appear to break down. If anything, trading activity increases as prices fall abruptly, to decline only later as crises progress. However, the cost of making transactions increases sharply; prices react more strongly to each dollar transacted and bid-ask spreads widen. (See figures below.) Thus, whereas trading activity moves inversely to trading costs during tranquil times (and across securities), both increase during crises.

These results are consistent with the view that crises are associated with portfolio reallocation among heterogeneous agents that do not fully anticipate crises (hence, volume increases during market downturns, rather than before) and with fire sales by liquidity constrained investors paying a hefty premium to bring in outside capital. The results also suggest that distressed reallocations between liquid and illiquid investors are feasible but costly.

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6 Responses to "Liquidity Crises: The Functioning of Secondary Markets"

  1. Vitoria Saddi   September 20, 2007 at 3:45 pm

    Sergio: Do you think that the results are similar if you add in your sample less traded shares? By adding only ‘elite group’ of shares, I can intuitively understand that the increase in the bid – ask spread during crises for these elite shares. It is harder to see if similar results (wider bid-ask) for less traded shares. I guess this part of the market (which is a large share) may indeed simply shut down, or not?

  2. Sergio   September 20, 2007 at 9:12 pm

    Vitoria,  Thanks very much for your comment.  The problem when looking at less traded stocks is that the series are much more volatile and, importantly, that there are many missing observations, probably due to non-trading activity. We focused on stocks that trade almost everyday so we can track the evolution of bid-ask spreads and we can compute the Amihud ratio. As an alternative measure we also looked at the proportion of non-trading days.  It is possible that less traded stocks behave differently, and their markets indeed shut down during crises. However, we have looked at many stocks before doing the analysis, including “non-elite” stocks. Casual observation suggests most stocks analyzed show similar patterns, within countries and across countries. But as your comment suggests, much more analysis is needed.  Thanks again,

  3. Anonymous   September 21, 2007 at 8:13 am

    This is a most inteesting analysis and study; do we know if such effects do occur also in other asset markets when there is a seizure of credit and liquidity. In recent period of global financial turmoil it looks like secondary trading was frozen in many assets (CDOs, ABCP, etc…). How come?

  4. Nouriel   September 21, 2007 at 8:17 am

    Sergio, a real excellent contribution and point that you are making. But in some market the freezing of liquidity may lead to little secondary market activity. The assets of many conduits and SIVs are now frozen and there is very little trading in them. Partly this may be due to the fact that some financial claims (say tranches of CDOs) were little traded even in good times; thus, in periods of crunch they become even more illiquid. This suggest the need to create deep and liquid markets for such eminently illiquid assets.

  5. Sergio   September 21, 2007 at 10:57 am

    Thanks for your feedback.  I agree with the two comments above. We need to understand what happens in other markets. From the research point of view, one problem is that it is difficult to get good time series on those securities (although I am sure that some institutions do have them).   But the claim that markets shut down refers to secondary markets in general. Perhaps, this type of research would help to clarify the discussion.

  6. Anonymous   August 15, 2008 at 8:58 pm

    This is a very interesting research. I wonder if there are other market liquidity indicators rather than bid-ask spread?