The author interestingly writes that the presence of liquidity problems in the largest markets suggests that liquidity is not about size, but diversity of market participants. Although this article was written in 2003, it remains more than ever relevant in the current markets.
Interesting extracts from the article:
"In an illiquid market the same size of sell order will push the market down further than in a liquid market. Imagine a market where there is a large number of market participants, using the exact same information set, in the exact same way, to trade the exact same financial instruments. When one buys they all do and vice versa. Market participants would face volatility and illiquidity when they came to buy or sell. This would not be reduced by having more players, only by increasing the amount of diversity in their actions. (Indeed, on these assumptions it is possible to show that the bigger the market was, the less liquid it would be). Now imagine a market with just two players but with opposite objectives or opposite ways of defining value. When one wants to buy the other wants to sell. This market is small, but the price impact of trading would be low and liquidity would be high."
"Diversity matters and probably more so than size in the development of liquid financial markets. Markets can be large, but prone to troublesome liquidity black holes if they are not diverse. This can be seen in the foreign exchange markets today and there are worrying signs that diversity is falling in other major financial markets. Diversity relates to numbers of players and instruments, but in markets prone to herding, a critical role is played by the diversity of decision rules. Market-sensitive risk management systems reduce diversity of decision rules and the encouragement by regulators for these systems to be used across industry players will increase the number of liquidity black holes."
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