Liquidity Risk, Speculative Trade, and the Optimal Latency of Financial Markets

Daniel Fricke and Austin Gerig

Abstract:

Garbade and Silber (1979) demonstrate that an asset will be liquid if it has (1) low price volatility and (2) a large number of public investors who trade it. Although these results match nicely with common notions of liquidity, one key element is missing: liquidity also depends on (3) an asset's correlation with other securities. For example, if an illiquid asset is highly correlated with a liquid asset, then speculators will naturally step in and "make it liquid". In this paper, we update Garbade and Silber's model to include an infinitely liquid market security. We show that when the market security is added, the liquidity of the original asset is an increasing function of its correlation with the market. Furthermore, we show that at a critical correlation value of [square root of 3/4] it is optimal for the asset to continuously clear, i.e., for orders to transact immediately when placed in the market. This low-latency result holds regardless of the other properties of the asset. The updated model can help answer several questions relevant to current financial markets: "How and why do short-term speculators provide liquidity in markets?", "How much benefit do these speculators add?", and "Can extremely low-latency in markets be beneficial?"