- 2008, 48
The impact of hidden liquidity in limit order books
- We report evidence that the presence of hidden liquidity is associated with greater liquidity in the order books, greater trading volume, and smaller price impact. Limit and market order submission behavior changes when hidden liquidity is present consistent with at least some traders being able to detect hidden liquidity. We estimate a model of liquidity provision that allows us to measure variations in the marginal and total payoffs from liquidity provision in states with and without hidden liquidity. Our estimates of the expected surplus to providers of visible and hidden liquidity are positive and typically of the order of one-half to one basis points per trade. The positive liquidity provider surpluses combined with the increased trading volume when hidden liquidity is present are both consistent with liquidity externalities.
- 2008, 31
The future of securitization
Jan Pieter Krahnen
- Securitization is a financial innovation that experiences a boom-bust cycle, as many other innovations before. This paper analyzes possible reasons for the breakdown of primary and secondary securitization markets, and argues that misaligned incentives along the value chain are the primary cause of the problems. The illiquidity of asset and interbank markets, in this view, is a market failure derived from ill-designed mechanisms of coordinating financial intermediaries and investors. Thus, illiquidity is closely related to the design of the financial chains. Our policy conclusions emphasize crisis prevention rather than crisis management, and the objective is to restore a “comprehensive incentive alignment”. The toe-hold for strengthening regulation is surprisingly small. First, we emphasize the importance of equity piece retention for the long-term quality of the underlying asset pool. As a consequence, equity piece allocation needs to be publicly known, alleviating market pricing. Second, on a micro level, accountability of managers can be improved by compensation packages aiming at long term incentives, and penalizing policies with destabilizing effects on financial markets. Third, on a macro level, increased transparency relating to effective risk transfer, risk-related management compensation, and credible measurement of rating performance stabilizes the valuation of financial assets and, hence, improves the solvency of financial intermediaries. Fourth, financial intermediaries, whose risk is opaque, may be subjected to higher capital requirements.