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The Empirical Analysis of Liquidity

We provide a synthesis of the empirical evidence on market liquidity. The liquidity measurement literature has established standard measures of liquidity that apply to broad categories of market microstructure data. Specialized measures of liquidity have been developed to deal with data limitations in specific markets, to provide proxies from daily data, and to assess institutional trading programs. The general liquidity literature has established local cross-sectional patterns, global cross-sectional patterns, and time-series patterns. Commonality in liquidity is prevalent. Certain exchange designs enhance market liquidity: a limit order book for high volume markets, a hybrid exchange for low volume markets, and multiple competing exchanges. Automatic execution increases speed, but increases spreads. A tick size reduction yields a large improvement in liquidity. Providing ex-post transparency to an otherwise opaque market dramatically improves liquidity. Opening up the limit order book improves liquidity. Regulatory reforms that increase the number of competitive alternatives, move toward linking them up, and level the playing field between exchanges improves liquidity. High-frequency traders trade in both a passive, liquidity-supplying manner and an aggressive, liquidity-demanding manner. Their overall impact improves both liquidity and price efficiency, but concerns remain regarding occasional trading glitches, order anticipation strategies, and latency arbitrage at the expense of slow traders. The liquidity and corporate finance literature provides abundant evidence that liquidity is beneficial in many corporate settings: liquidity increases the power of governance via exit, reduces the cost of governance via intervention, facilitates the entrance of informed traders who produce valuable information about the firm, enhances the effectiveness of equity-based compensation to managers, reduces the cost of equity financing, mitigates trading frictions investors encounter when trading in the market to recreate a preferred payout policy, and lowers the immediate transaction costs and subsequent liquidity costs for firms conducting large share repurchases. Further, the influence goes both ways. There is evidence that firms influence their own liquidity through a broad range of corporate decisions including internal governance standards, equity issuance form and pricing, share repurchases, acquisition targets, and disclosure timeliness and quality. The literature on liquidity and asset pricing demonstrates that both average liquidity cost and liquidity risk are priced, liquidity enhances market efficiency, and liquidity strengthens the arbitrage linkage between related markets. We conclude with directions for future research.