Illiquid Securities Research Articles

Investment management approaches: A comprehensive review of equity trading simulators, methodological challenges, and future directions

This paper provides a comprehensive review of equity trading simulators, focusing on their performance in assuring pre-trade compliance and portfolio investment management. A systematic search was conducted that covered the period of January 2000 to May 2023 and used keywords related to equity trade simulators, portfolio management, pre-trade compliance, online trading, and artificial intelligence. Studies demonstrating the use of simulators and online platforms specific to portfolio investment management, written in English, and matching the specified query were included. Abstracts, commentaries, editorials, and studies unrelated to finance and investments were excluded. The data extraction process included data related to challenges in modern portfolio trading, online stock trading strategies, the utilization of deep learning, the features of equity trade simulators, and examples of equity trade simulators. A total of 32 studies were included in the systematic review and were approved for qualitative analysis. The challenges identified for portfolio trading included the subjective nature of the inputs, variations in the return distributions, the complexity of blending different investments, considerations of liquidity, trading illiquid securities, optimal portfolio execution, clustering and classification, the handling of special trading days, the real-time pricing of derivatives, and transaction cost models (TCMs). Portfolio optimization techniques have evolved to maximize portfolio returns and minimize risk through optimal asset allocation. Equity trade simulators have become vital tools for portfolio managers, enabling them to assess investment strategies, ensure pre-trade compliance, and mitigate risks. Through simulations, portfolio managers can test investment scenarios, identify potential hazards, and improve their decision-making process.

Article: Equity Crowdfunding and Mini-Bonds: A Tool for the Economic Recovery of SMEs: Ratio, Dangers and Prospective in the UK and Italian Jurisdictions

The following paper, after briefly outlining what mini-bonds and equity crowdfunding platforms consist, will deal with the regulations in the UK and in Italy to regulate the placement of mini-bonds through crowdfunding platforms in a second chapter, outlining the similarities and divergences of methods and purposes with which they were conceived in the two countries. In a third chapter the advantages and disadvantages with regard not only to the placement of mini-bonds through crowdfunding platforms for SMEs that issue mini-bonds, but also for consumers will be analysed. Finally, in the last chapter the author will try to clarify and justify the ban by the FCA to retail investors for purchase of “speculative illiquid securities” also due to the numerous scandals that occurred in the UK, but at the same time, proposals will be put forward aimed at better regulating the phenomenon and encouraging the use of this alternative financial instrument. Mini-bonds, crowdfunding, alternative finance, fintech, financial technologies, comparative law, SMEs, economic policies, Italian jurisdiction, UK jurisdiction.

Emergency liquidity injections

This paper models emergency liquidity injection policies intended to prevent illiquidity-driven bank failures. A system-wide withdrawal of funding liquidity causes bank failures if banks’ securities have low market liquidity relative to the withdrawal size. The model presents several policy implications. Requiring banks to collateralise emergency lending with illiquid securities has positive externalities in the securities’ secondary markets, by constraining banks’ fire selling. For penalty rates on emergency lending to credibly mitigate moral hazard, the loans should be long term, due after the liquidity distress subsides. Additional policy implications relate to penalty rates, haircuts and government balance-sheet expansion.

Estimating Risk in Illiquid Markets: A Model of Market Friction with Stochastic Volatility

Abstract This article deals with the problem of estimating the volatility of a financial security in a market with frictions. We propose a microstructural model with time-varying fundamental price volatility in which the trading price varies only if the value of the information signal is large enough to guarantee a profit in excess of transaction costs. Using transaction data only, the proposed approach allows to recover: (i) the conditional volatility of the information signal, which is thus cleaned out by market frictions and (ii) an estimate of transaction costs. Our analysis reveals that, after correcting for frictions, the risk of illiquid securities is substantially different from what is predicted by traditional volatility models. Furthermore, using a big dataset of intraday returns, we show that our transaction cost estimate is highly correlated with the main illiquidity measures and that such correlations are significant under different volatility regimes.

Emergency Liquidity Injections

This paper compares the effectiveness of different forms of emergency liquidity injections, including secured lending (repo), unsecured lending and securities purchases. The model features an endogenous banking crisis, funding and market liquidity interactions, and fire sale externalities. Injection policies are compared by their effects on ex ante incentives and on ex post outcomes. The model demonstrates that lending to banks via repo can curb fire selling of relatively illiquid securities that are accepted as collateral, due to binding collateral constraints. The mitigated securities price depression, relative to an unsecured lending policy, counteracts the effects of fire sale externalities. This reduces banks' losses on illiquid securities without incentivising more liquidity risk-taking. Under an unsecured or secured lending policy, the authority can charge 'penalty rates' to deter liquidity risk-taking, but to be credible, lending should be long term so that repayments are due after liquidity conditions improve. Otherwise, the repayments can cause further liquidity distress, compromising the policy objectives. Liquidity injections via securities purchases cannot credibly be penalising, because the policy does not require banks to commit future income.

Liquidity risk and stock returns: empirical evidence from industrial products and services sector in Bursa Malaysia

This study investigates the impact of liquidity risk on stock returns of 149 firms in the industrial products and services sectors of Bursa Malaysia from January 2000 to December 2018 with a monthly frequency dataset. This study employed the two-stage standard procedures in asset pricing to estimate the significant effect of liquidity risk on industrial products and services stock returns. The results show that the investors require liquidity premium for stocks whose illiquidity co-moves with market illiquidity and market return while shifting their investment to liquid stocks when the market becomes illiquid, thus positive premium for stocks whose return is higher during the illiquid market. It suggests that two liquidity risks, namely commonality in liquidity and the covariances between stock illiquidity and market returns, and aggregate liquidity risk explain the cross-sectional returns variations across stocks in the industrial products and services sector, thus partly support the LCAPM model. We provide evidence on the important role of liquidity risks on the cross-sectional industrial products and services stock returns in Bursa Malaysia in the LCAPM framework. The findings of this study may be useful for investment decision-making and portfolio allocation strategy under the liquid and illiquid securities conditions. For policymakers, understanding the impact of liquidity risks on stock returns for the industrial products and services sectors may help enhance market liquidity for economic growth. Therefore, our findings contribute to the practical and policy implications.

A Structural Model of Market Friction with Time-Varying Volatility

We propose a model of price formation in which the trading price varies only if the value of the information signal is large enough to guarantee a profit in excess of transaction costs. Using transaction data only, we extract: (i) the conditional volatility of the underlying security, which is thus cleaned out by market frictions, (ii) an estimate of transaction costs. Our analysis reveals that, after correcting for frictions, the risk of illiquid securities is substantially different from what predicted by traditional volatility models. Furthermore, in periods of high volatility, our estimate of transaction costs remains highly correlated with bid-ask spreads, whereas alternative illiquidity proxies, such as the fraction of zero returns, loose their explanatory power.

The Money Market Mutual Fund Liquidity Facility

In this article, we discuss the run on prime money market funds (MMFs) that occurred in March 2020, at the onset of the COVID-19 pandemic, and describe the Money Market Mutual Fund Liquidity Facility (MMLF), which the Federal Reserve established in response to it. We show that the MMLF, like a similarly structured Federal Reserve facility established during the 2008 financial crisis, was an important tool in stemming investor outflows from MMFs and restoring calm in short-term funding markets. The usage of the facility was higher by funds that suffered larger outflows. After the facility’s introduction, outflows from prime MMFs decreased more for those funds that had a larger share of illiquid securities. Importantly, following the introduction of the MMLF, interest rates on MMLF-ineligible securities decreased at a slower rate than those on MMLF-eligible securities, even after controlling for credit risk.

COVID Response: The Money Market Mutual Fund Facility

In this article, we discuss the run on prime money market funds (MMFs) that occurred in March 2020, at the onset of the COVID-19 pandemic, and describe the Money Market Mutual Fund Liquidity Facility (MMLF), which the Federal Reserve established in response to it. We show that the MMLF, like a similarly structured Federal Reserve facility established during the 2008 financial crisis, was an important tool in stemming investor outflows from MMFs and restoring calm in short-term funding markets. The usage of the facility was higher by funds that suffered larger outflows. After the facility’s introduction, outflows from prime MMFs decreased more for those funds that had a larger share of illiquid securities. Importantly, following the introduction of the MMLF, interest rates on MMLF-ineligible securities decreased at a slower rate than those on MMLF-eligible securities, even after controlling for credit risk.

Mutual Fund Liquidity Transformation and Reverse Flight to Liquidity

We identify fixed-income mutual funds as an important contributor to the unusually high selling pressure in liquid asset markets during the Covid-19 crisis. We show that mutual fund liquidity transformation led to pronounced investor outflows. In meeting redemptions, funds followed a pecking order by first selling their liquid assets, including Treasuries and high-quality corporate bonds, which generated the most concentrated selling pressure in these markets. The Fed's announced purchase of illiquid securities effectively stabilized mutual fund liquidity transformation and alleviated the selling pressure in liquid asset markets.

Quote-Based manipulation of illiquid securities

We document the effects of a manipulation akin to marking the close, conducted without any manipulative trades. Using prosecuted cases, we examine how manipulators can utilize periods of order-book illiquidity to navigate ill-conceived market design rules and influence security prices. Reference pricing, which has gained significant attention recently in interest rate and metals markets, is shown to contribute to significant increases in end of day returns for affected securities, with no observable subsequent reversals. We show that the price effects continue in the manipulated direction over extended periods, with average excess returns over 80% in the six months after manipulation.

Quantum coupled-wave theory of price formation in financial markets: Price measurement, dynamics and ergodicity

We explore nature of price formation in financial markets and develop a theory of bid and ask price dynamics in which the two prices form due to quantum-chaotic interaction between buy and sell orders. In this model bid and ask prices are represented by eigenvalues of a 2x2 price operator corresponding to “bid” and “ask” eigenstates, while randomness of price operator results in price fluctuations that destroy oscillatory effects. We show that this theory adequately captures behavior of bid–ask spread and allows to model bid and ask price dynamics in a coordinated way. We also discuss ergodicity properties of price formation and show how directional price movement occurs due to ergodicity violation in a quantum process instead of the commonly believed forces acting on price. This theory has wide range of applications such as trade execution modeling, large order pricing and risk valuation for illiquid securities.

Unconventional Monetary Policy and Funding Liquidity Risk

This paper investigates the efficiency of various monetary policy instruments to stabilize asset prices in a liquidity crisis. We propose a macro-finance model featuring both traditional and shadow banks subject to funding risk. When banks are well capitalized, they have access to money markets and efficiently mitigate funding shocks. When aggregate bank capital is low, a vicious cycle arises between declining asset prices and funding risks. The central bank can partially counter these dynamics. Increasing the supply of reserves reduces liquidity risk in the traditional banking sector, but fails to reach the shadow banking sector. When the shadow banking sector is large, as in the US in 2008, the central bank can further stabilize asset prices by directly purchasing illiquid securities. JEL Classification: E43, E44, E52, G12

Repo Rates and the Collateral Spread Puzzle

Repo rates frequently exceed unsecured rates in practice. As an explanation, this paper derives a constrained-arbitrage relation between the unsecured rate, the repo rate, and the illiquidity adjusted expected rate of return of the underlying collateral. The theory is based on unsecured borrowing constraints in the market for liquidity. Repos and security cash-market trades are alternative means to get liquidity. Collateral spreads (unsecured less repo rate) can turn negative if borrowing constraints tighten, unsecured rates spike down, or from a depressed and illiquid security market. The constrained-arbitrage theory sheds light on the evolution of collateral spreads over time.

Unconventional Monetary Policy and Funding Liquidity Risk

This paper investigates the efficiency of various monetary policy instruments to stabilize asset prices in a liquidity crisis. We propose a macro-finance model featuring both traditional and shadow banks subject to funding risk. When banks are well capitalized, they have access to money markets and efficiently mitigate funding shocks. When aggregate bank capital is low, a vicious cycle arises between declining asset prices and funding risks. The central bank can partially counter these dynamics. Increasing the supply of reserves reduces liquidity risk in the traditional banking sector, but fails to reach the shadow banking sector. When the shadow banking sector is large, as in the US in 2008, the central bank can further stabilize asset prices by directly purchasing illiquid securities.

Internal Valuation of Assets with Liquidity Risk

FVA, funding valuation adjustment, is a new and controversial adjustment to the value of a firm’s derivatives position, joining CVA (credit valuation adjustment) and DVA (debt valuation adjustment), both of which attempt to account for the effects of counterparty credit risk on the value of a contract on a firm’s books. FVA adjusts for the fact that an investor who holds a security but finances it in the money market will have to pay a premium over the riskless rate in order to do so. This premium reduces the investment value of the position by an amount that is supposed to be captured by the FVA. The problem that Nauta raises is that this treatment does not distinguish between a security that is traded in a liquid market and can be sold for its fair value at any time, meaning overnight funding is OK, versus an illiquid security that must be financed through maturity. The article shows how this key difference translates into a liquidity-based FVA and an optimal funding horizon for less than perfectly liquid assets. <b>TOPICS:</b>Counterparty risk, quantitative methods, credit risk management

Mutual Fund Flight-to-Liquidity

This paper examines the liquidity choices of mutual funds during times of market uncertainty. I find that when markets are uncertain, mutual funds actively increase the liquidity of their portfolio – often referred to as a ‘flight-to-liquidity.’ In aggregate, mutual fund behaviour has implications for the market; the market driven flight-toliquidity places upward pressure on the liquidity premium. I examine the underlying mechanisms driving fund behaviour. I show that market volatility is associated with lower fund performance and withdrawals, which causes funds to adjust the composition of their portfolio towards more liquid assets in order to meet potential redemptions. This causal chain is consistent with Vayanos (2004), who argues that fund managers are investors with time-varying liquidity preferences due to threat of withdrawal. Aggregated over funds, the effect is substantial: a one standard deviation increase in my measure of flight-to-liquidity yields a 0.63 standard deviation increase in the excess return required for holding illiquid securities.

Inefficiencies in the Pricing of Exchange-Traded Funds

The prices of exchange-traded funds (ETFs) can deviate significantly from their net asset values (NAVs), in spite of the arbitrage mechanism that allows authorized participants to create and redeem shares for the underlying portfolios. The deviations, typically within a band of about 200 bps, are larger in funds holding international or illiquid securities. To control for stale pricing of the underlying assets, I introduce a novel approach that uses the cross section of prices on a group of similar ETFs. The average pricing band remains economically significant at about 100 bps, with even larger mispricings in some asset classes. Active trading strategies exploiting such inefficiencies produce substantial abnormal returns before transaction costs, providing further proof of short-term mean reversion in ETF prices.

Simulating Fire-Sales in a Banking and Shadow Banking System

We develop an agent based model of traditional banks and asset managers. Our aim is to investigate the channels of contagion of shocks to asset prices within and between the two financial sectors, including the effects of fire sales and their impact on financial institutions’ balance sheets. We take a structural approach to the price formation mechanism as in Bluhm, Faia and Kranen (2014) and introduce a clearing mechanism with an endogenous formation of asset prices. Both types of institutions hold liquid and illiquid assets and are funded via equity and deposits. Traditional banks are interconnected in the money market via mutual interbank claims, where the rate of return is endogenously determined through a tatonnement process. We show how in such a set-up an initial exogenous liquidity shock may lead to a fire-sale spiral. Banks, which are subject to capital and liquidity requirements, may be forced to sell an illiquid security, which impacts its, endogenously determined, market price. As the price of the security decreases, both agents update their equity and adjust their balance sheets by making decisions on whether to sell or buy the security. This endogenous process may trigger a cascade of sales leading to a fire-sale. We find that, first, mixed portfolios banks act as plague-spreader in a context of financial distress. Second, higher bank capital requirements may aggravate contagion since they may incentivise banks to hold similar assets, and choose mixed portfolios business model which is also characterized by lower levels of voluntary capital buffer. Third, asset managers absorb small liquidity shocks but they exacerbate contagion when liquid buffers are fully utilised.

Risk Valuation for Securities with Limited Liquidity

Professional market participants have to deal with illiquid securities on a constant basis. For such securities traditional risk assessment techniques fail. This can lead to underestimated and distorted results for the entire investment portfolio, and ultimately to inadequate risk management. We present a framework, based on coupled-wave model, that allows to model securities with low liquidity and evaluate impact of various risk sources, associated with liquidity. In addition to risk management, this framework should be helpful to firms and trading desks in evaluating cost of liquidity and selecting liquidation tactics for their oversize positions.