A Monte Carlo analysis of the determinants of market liquidity and its implications for regulatory policymakers

Abstract

The paper aims to understand the determinants of bid-ask spread and how the liquidity within a dealer-driven financial market is affected by different rules and behaviours. As the output of the three-agent Monte Carlo simulation within this paper shows, the liquidity of financial markets can be considered to be a rather complex phenomenon. The paper also distinguishes low, medium and high levels of information asymmetry. The simulation results confirm that informed traders contribute to wider spreads due to a high level of information asymmetry while at medium and low degrees of information asymmetry, the proportion of informed traders increases the liquidity before decreasing. This result supports the arguments postulated by the theoretical background of some empirical works which surprisingly find that liquidity increases when there is more active informed trading. Four important economic implications have been addressed as a consequence of the results. These are related to the efficiency of the regulation, the limitations of micro-and macroprudential regulation, central bank policy and the commonality in liquidity.