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Liquidity and transaction costs: Two important criteria of market quality

In the discussion about the relative advantages of securities markets, two factors are regularly the focus of attention: liquidity and transaction costs. In the framework of portfolio restructuring, liquidity is by far the most important decision-making criterion for investors (Schiereck [1995]) and is regarded as the central quality characteristic in securities markets.

At the macro-level, liquid capital markets are essential for the efficiency of capital allocation in modern economies and lead to low cost of capital for issuers. At the micro-level, a liquid market enables access to a large number of trading interests and thus ensures that investors can carry out their transactions at any time.

In order to maximize the net return on an investment in securities, it is especially important for investors to be able to execute their buy and sell transactions at the lowest possible transaction costs. Therefore, the anticipated transaction costs should ideally be included as a decision-making criterion when deciding on a specific investment, i.e. stock picking, so that securities can be compared and/or benchmarked in terms of the anticipated net return.

Although the importance of liquid markets and low transaction costs is undisputed, there is neither a uniform understanding of the term liquidity, nor an operational model for the integrative analysis of liquidity and transaction costs.

With this motivation in mind, Deutsche Börse AG has set out to structure the discussion of liquidity and put it on a more objective footing. The goal is to identify a measure of liquidity based on transaction-cost analysis that quantifies liquidity in a single figure. To do this, the so-called Market Impact is being introduced as the Xetra Liquidity Measure. This figure rates the liquidity of the traded instruments on the basis of a uniform methodology and provides investors with a tool for the objective assessment of the trading costs. On this basis, the liquidity of individual securities as well as whole marketplaces can be analyzed in a comparable and transparent manner.

To read further on this topic go to:

http://deutsche-boerse.com/dbag/dispatch/en/binary/gdb_content_pool/imported_files/public_files/10_downloads/31_trading_member/10_Products_and_Functionalities/40_Xetra_Funds/30_Xetra_Liquidity_Measure/liq_wph.pdf

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