The time-varying effects of liquidity and market efficiency of the European Union carbon market: Evidence from the TVP-SVAR-SV approach

Abstract

We use the time-varying parameter structural vector autoregression stochastic volatility (TVP-SVAR-SV) and causality-in-quantiles methods to explore the linkage between market liquidity and efficiency in the European Union Emissions Trading Scheme (EU ETS) during Phase III. Our findings indicate that two-way causality existed under normal and lower market conditions. Additionally, the linkage between liquidity and efficiency exhibits time-varying characteristics. Except in cases of extremely high market liquidity, the pass-through effect of liquidity on efficiency is mostly positive in the long run. The linkage is particularly stronger in the medium and long term. However, the response of liquidity to efficiency shocks is more complicated. Market efficiency generally has an overall inhibitory effect on liquidity in the short term and a promoting effect in the medium and long term. Furthermore, we investigate the impulse response during the COVID-19 period and the war between Russia and Ukraine and find that improvements in efficiency will permanently damage liquidity. Overall, the abilities of market makers and arbitrage traders, impacted by multiple factors, play an important role in the process by which liquidity affects market efficiency. By revealing and explaining the dynamic relationship between liquidity and efficiency, this research provides valuable information for policymakers and various market participants.