The Impact of Trade Execution on Market Liquidity and Efficiency

Trade execution is central to not only liquidity but also the efficiency of investment markets. In some areas, it is easy to draw the subjects together, but when considered in isolation this gives you the broader picture. In its simplest form, trade execution is simply the completion of a buy/sell order between two parties. How a trade is executed will directly impact market liquidity and market efficiency.

 

Factors Affecting Trade Execution Quality

 

Many factors will impact the quality of trade execution across all investment markets. These include:-

 

• Market volatility
• Liquidity
• Order size
• Order type
• Trading venue

 

Many traders will pinpoint speed as the significant factor when executing investment trades. True, especially in a volatile market, speed will be critical, but there is also efficiency in how the trade is carried out. 

 

Liquidity is, in some ways, a measure of efficiency, how quickly you can buy and sell a particular investment in "decent size". This then brings us onto order sizes, with many markets defining a minimum order size to indicate minimum liquidity. Then order sizes will link to order types, for example, the efficient trading of limit orders. So you now get an indication of how all of the different elements are interconnected.

 

Finally, we come to trade venues which in the modern era tend to be electronic and are extremely fast. As a result, modern-day trading systems have encouraged day traders who considerably improve liquidity.

 

Trade Execution and Market Liquidity

 

As we touched on above, when investors have confidence in their trade execution system, they tend to trade more frequently. Since the inception of electronic trading, we have seen many day traders and short-term traders joining the investment arena. While sometimes criticised as short-term predators, short-term traders can actually give investments a significantly enhanced level of liquidity. The simple measure of a liquid market is one where the buying and selling of large amounts of shares in one trade has a negligible impact on the share price - which suggest there is depth to the market.

 

Liquidity is also based on what is known as the "free float", which is the number of shares not in firm hands. If more shares are in safe hands, then there will be a reduced free float which could prompt liquidity issues and subsequent volatility. Therefore, if you have short-term traders buying and selling shares regularly, this will increase liquidity. This then allows some of the larger investment funds to become involved, as they know they can deal in “decent size” when looking to buy and sell. 

 

Conversely, shares with relatively low liquidity levels are unlikely to attract large investors and investment funds, which would have benefited liquidity in the longer term. Something of a vicious circle. Where do you start?

 

Trade Execution and Market Efficiency

 

As we touched on above, trade execution filters into liquidity which impacts market efficiency. For example, if you have an asset bought and sold once every 12 months, there is no way to determine the price between these dates. On the other hand, an efficient trade execution system will allow shares to be bought and sold in theory every second; therefore, you have a market price in an instant.

 

If you imagine the markets as information exchanges, we have trades, opinions and research impacting sentiment in real-time. All of this enters the information exchange, which then dictates the market price for that asset. The more information available, the more confident investors are of the market price, which improves liquidity, greater efficiency and so on. Consequently, poor liquidity, limited news and a lack ofresearch will give markets minimal information on which to calculate the “real price”. If investors are less confident of the “real price” they will be more reluctant to trade.

 

Conclusion

 

At first glance, it is easy to assume that just one or two elements significantly impact market liquidity and efficiency. Of course, trade execution is one of the most influential factors, but behind trade execution, you have an array ofdifferent factors. Undoubtedly, the electronic age has brought dealing systems to a level which was inconceivable just 20 years ago. The ability to deal directly with markets has encouraged day traders, increasing liquidity, bringing more prominent investors on board, further enhancing liquidity, etc.

 

In theory, trade execution is simply a transaction between two parties when in reality, the price is impacted by many different factors.

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