Liquidity: The cornerstone of efficient markets
The U.S. capital markets are the world’s most efficient; they are unrivaled in terms of their size, technology, strong regulatory controls, and breadth of market participants. A high degree of liquidity and depth are crucial elements of the market’s efficiency because, without both, corporations and government agencies would face difficulties raising large amounts of long-term capital quickly and cost effectively.
In liquid and deep markets, selling or buying can be done with minimal effect on the prevailing competitively established price. One advantage of a liquid market for customers is immediacy: the ability to sell quickly when they need cash or to buy quickly when there is a chance for a gain.
Timely, dependable clearance and settlement of trades are also important factors in maintaining liquid markets. Investors now receive proceeds from sales within three days, but they must also deliver the securities needed for a sale or a check in case of purchase within that same period.
Dealer markets achieve liquidity through market makers, who must stand ready to buy or sell a specific quantity of stocks at the price they quote. Specialists on exchange markets match buy and sell orders or step into the other side of an order to complete the transaction. Market makers and specialists must display customer limit-orders that improve certain quotes or increase the size of such quotes.
Market making in dealer and auction markets is an inherently risky business, however, and in volatile markets, dealers may sustain losses on their inventories. They also buy securities that investors are trying to sell during periods of declining prices.
However, risk also begets reward when market makers earn fees from the transactions they help complete. Secondary markets also perform valuation and allocation functions. Investors monitor market prices to calculate the costs of securities they own or wish to buy.
Underwriters price new securities issues based partly on market valuations of similar companies. When values shift, secondary markets facilitate the flow of capital from areas where growth is slackening to sectors where capital is needed to finance expansion. To fulfill their valuation functions, secondary markets depend on substantial transaction volume.
Securities firms continuously develop new investment products and financing techniques to better satisfy client needs and to enhance market liquidity. Derivatives — a form of financial contract whose value depends on, or derives from, an underlying instrument or asset — provide additional means for investors and companies to tailor their “risk profile” to suit their preference.
Through the use of such instruments, a business or investor can separate various risks, keeping those it prefers and selling others to which it would rather not be exposed. While derivatives are sometimes thought of as complex and esoteric, they are surprisingly common. For example, homeowners who are allowed to pre-pay their mortgage essentially hold an option (a contract that permits a party to buy or sell an asset at a given price within a specified time) embedded in the mortgage.
These instruments have been used for years to manage conventional risks — such as interest rate and currency risks — in the marketplace. Financial evolution has led to the development of new classes of derivatives to manage a broad range of other risks. Derivatives do not introduce new risks into the financial system. They simply permit parties to manage risks more efficiently and provide greater liquidity to the capital markets. The development of new financial products has made the U.S. financial industry the global leader in risk management and financial innovation.