Does transparency impact market liquidity? : evidence from the European Union and United States equity markets
Abstract
We find evidence for increased market transparency to have a positive effect on equity market
liquidity. Using data from EU and US equity markets, we estimate the effect of the
implementation of the Markets in Financial Instruments Directive to increase liquidity in EU
stock markets. To measure different dimensions of market liquidity we use bid-ask spreads,
the percentage daily range, the Hui-Heubel liquidity ratio, the Market Efficiency Coefficient,
trading volume and Amihud’s Illiquidity ratio. These metrics are used to measure the tightness,
immediacy, breadth, resiliency, depth, and general liquidity of the market, respectively. We
use a staggered Difference-in-Difference analysis to estimate an increase in all liquidity
dimensions except immediacy, which decreases. This provides evidence for a positive
relationship between market transparency and liquidity, but also suggests that the increase in
some liquidity dimensions may come at the expense of others. However, for some of the
liquidity metrics it is doubtful whether the parallel trends assumption holds, which limits the
causal interpretation of these findings. The results should therefore be interpreted with caution.
Although we do not provide a conclusive answer regarding the mechanisms through which
transparency affects liquidity, we argue that the positive liquidity effects likely come as
transparency lowers risk for price-setting market makers while also causing traders to change
their strategies in ways that are conducive to liquidity.