Have Financial Markets Become More Liquid?

Abstract

As investors shift their focus from average liquidity to liquidity risk, relying solely on average measures to claim markets are more liquid can be misleading. We document that as the mean of bid-ask spreads decreased over recent decades, their skewness increased. To understand why this has occurred, we examine how two key features of modern markets-high-frequency trading (HFT) and dark trading (DT)-affect bid-ask spread skewness. We find HFT increases skewness, while DT decreases it. The mean bid-ask spread is priced in NYSE stocks only, and only before 2008. In contrast, bid-ask spread skewness is priced in Nasdaq stocks throughout the 1996-2022 period, with an average monthly premium of 22 bps. We further analyse the drivers of illiquidity premiums associated with the mean and skewness of the bid-ask spread.

Keywords: Liquidity, asset returns, skewness, high frequency trading, dark trading

JEL Classification: G10, G12, G14