- As a metric for liquidity risk, total transaction cost can be split into a size-independent bid-ask spread and a market impact, the latter of which is larger for larger trades.
- Our analysis of the 2008 financial crisis shows that market impact almost quadrupled for U.S. high-yield financial-sector bonds, while the largest bid-ask increase was around 100%.
- Investors often consider bid-ask spread the exclusive measure of liquidity, while overlooking market impact — another key metric, especially in turbulent times.
Risk managers at investment funds are more and more focused on liquidity risk, as regulators have recently issued guidance that increases demands for liquidity stress testing.1 Although markets are currently considered fairly calm, the 2008 financial crisis showed how liquidity can deteriorate quickly under stressed conditions, resulting in widened bid-ask spreads. But by focusing solely on the change in bid-ask spreads, could investors underestimate their liquidity risk? The often-overlooked market impact2 — or the additional cost on top of the bid-ask cost3 for large trades — could also increase significantly, driving transaction costs still higher.
Crisis-era data illustrates the importance of market impact
To investigate how severe market events affected liquidity, we analyzed dealers’ quote data for corporate bonds during the 2008 crisis. The exhibit below shows how the bid-ask spread and market impact changed as a result of the crisis, for trades of USD 10 million in various segments of the corporate-bond market. In each segment, the cost is shown as a percentage of the pre-crisis bid-ask cost, and the total cost is broken down into bid-ask and market impact. Focusing on the bid-ask portion, we see that emerging markets suffered more than most other segments, although the biggest increase took place in U.S. financial-sector investment-grade bonds, where bid-ask costs more than doubled.
Looking at the market impact and the total transaction cost further refines the analysis. For example, the bid-ask cost for developed-market investment-grade bonds from Europe, the Middle East and Africa (EMEA) increased by 70% on average during the crisis. At the same time, the market impact went up by almost 400%; and as a result, the total transaction cost more than doubled.
The impact of the 2008 liquidity stress on the bond market
Bid-ask cost and total cost of a transaction of USD 10 million in various segments of the corporate-bond universe, before and during the financial crisis. The cost is expressed as a percentage of the pre-crisis bid-ask cost in each segment. We assume the scenario of forced selling within one day. Source: MSCI, IHS Markit.
The importance of market impact as a measure of liquidity risk becomes even more apparent when looking at the time evolution of transaction costs for U.S. corporate bonds in the financial sector. As the exhibit below illustrates, in the first six weeks after the Lehman Brothers bankruptcy, the impact on the bid-ask cost of investment-grade financial-sector bonds was even greater than that on high-yield securities. In terms of the total cost for transactions of USD 10 million, however, investment-grade bonds suffered less than lower-rated bonds.
Market impact after the Lehman collapse
Time series of the bid-ask cost and total cost of a transaction of USD 10 million, as a percentage of the pre-crisis bid-ask cost. Source: MSCI, IHS Markit.
A fuller picture of liquidity risk
In sum, risk managers preparing for events in which liquidity is severely impacted may be able to gain a fuller view of a portfolio’s liquidity risk by looking beyond bid-ask cost — and also considering market impact.
1 See, for example:
“Recommendations for Liquidity Risk Management for Collective Investment Schemes.” International Organization of Securities Commissions, Feb. 1, 2018.
“Open-ended Fund Liquidity and Risk Management — Good Practices and Issues for Consideration.” IOSCO, Feb. 1, 2018.
“Guidelines on liquidity stress testing in UCITS and AIFs.” European Securities and Markets Authority, Feb. 5, 2019.
2 Total transaction cost consists of the bid-ask cost and the market impact. The bid-ask-cost component is not sensitive to transaction size, but the market impact component is; that is, it increases if transaction size increases.
3 When we refer to bid-ask cost, we mean half the bid-ask spread, which is the transaction cost for small orders.