Liquidity in Lightly Regulated Markets – Lancelot

Liquidity is a multi-faceted phenomenon, referring simultaneously to the availability, cost and promptness of trading. Although difficult to define, it is a well-known key condition of well-functioning markets. In order to understand liquidity in markets characterized by opacity, we develop three main approaches: 1) theoretical modelling, 2) state-space modelling, and 3) empirical analyses.

We use game theory and auction theory to model the strategic behavior of market participants. Economic modelling leads to the formulation of testable empirical predictions.

State-space modelling allows understanding data when there are few observations. In OTC credit markets – a key market of the Great Financial Crisis –, there are on average two transactions per day.

Third we use empirical analysis to deepen our understanding of the impact of a lightly-regulated environment on liquidity. The articles that result from the project use a variety of techniques from panel-data and micro-econometrics, including panel regressions, logit regressions, competing risks duration regressions, propensity score matching, among others.

First, investigating the CDS market in the aftermath of the Lehman Brothers collapse, we find that liquidity of financial reference entities has improved in November 2008 after the release of aggregate data on the volume of CDS, corroborating that this transparency change helped to alleviate counterparty uncertainty. We also find that the CDS standardization made by the ISDA in 2009 (the Small Bang) made European CDS markets more liquid.

Second, we find that market participants in opaque markets may be induced to share information on price pressure in order to alleviate position risk, which improves liquidity, but violates codes of conduct.

Third, we find that secondary buy-outs - a way to enhance the liquidity of unused capital of PE funds - are mostly used by funds under pressure, and pressured funds tend to underperform.

Thanks to the efforts of the entire research team, the scientific and methodological objectives of the project Lancelot have been achieved. The valorisation of the various research papers is still undergoing and very promising.

The project has enabled the publication of 3 articles, of which one paper in a CNRS rank 1 journal, and of 5 working papers, of which 1 paper is also “Revise and Resubmit” in a CNRS rank 1 journal. Three of the articles resulting from the project have won international prizes. Finally the research team started in 2015 a fruitful collaboration with the German regulator.

This project aims at investigating issues related to liquidity in lightly-regulated markets.

Our working definition of a lightly-regulated market refers to securities markets characterized by one or more of the following features: (i) low levels of transparency regarding trading and market activity; (ii) weak reporting or disclosure obligations on the part of market participants regarding transactions, positions or leverage; (iii) absence of a centralized, mandatory clearing system. The project focuses, in particular, on alternative debt securities like Credit Default Swaps (CDS) and tradable syndicated loans, alternative markets (low-tier equity markets like NYSE Alternext), and alternative asset managers, like hedge funds or private equity funds.

We believe research on this topic is warranted for many reasons. First, lightly regulated markets and/or participants are large, particularly active, and have exhibited substantial growth rates in the past decades. Second, although numerous studies have investigated liquidity for equities, bonds or currencies, relatively less is known about the salient features of liquidity in lightly-regulated markets, like the CDS market, mostly due to the lower amount of data available to researchers. Third, the recent credit crisis has shown that the lightly-regulated systems may be a source of systemic risk, in particular due to their tight degree of interconnection with regulated markets. Understanding the liquidity characteristics of these new securities and how liquidity spillovers from one asset class to another can occur is, therefore, crucial to improving the functioning of these market segments.

Lightly-regulated markets trade over-the-counter in dealer-oriented markets, in which there is very little trade or quote transparency. This lack of information disclosure raises several challenging questions, which the project aims at addressing.

First, assembling market-wide data in these markets might be very costly, making research difficult. Moreover, even if data is available, the methods employed to measure liquidity in strongly regulated markets might not be readily applicable to the case of lightly regulated markets. This project tries to overcome these difficulties by developing appropriate methods to measure liquidity in these markets. The project then uses these measures to investigate liquidity provision, asymmetric information costs and price formation in these markets. Further, it analyzes the liquidity externalities of lightly-regulated markets on connected markets, like the bond market or the loan market.

Second, more and more issuers choose to issue securities through private placements or listing on low-tier equity markets (e.g., NYSE Alternext) that escape most of the mandatory rules contained in the European Union directives (MiFID). Lightly-regulated players like private-equity funds or hedge funds are big participants in these market segments. The project provides an enhanced study of the liquidity provision in these markets and analyzes reasons that lead firms to choose these lightly-regulated and low-disclosure modes of financing.

Finally, the emergence of lightly-regulated investors raises new questions on the trade-off between liquidity and monitoring and its links to governance mechanisms such as board independence, executive compensation, and investor protection. The project also analyzes the changes in the monitoring mechanisms of the companies that these investors acquire.

A peculiar feature of this research project is its multi-pronged empirical approach of analyzing issues related to liquidity, which we hope will contribute to build theoretical models and to feed the ongoing regulatory debate on lightly-regulated markets and participants.