Liquidity in the context of stock market means a market where large orders can be executed without incurring a high transaction cost. The transaction cost referred here is not the fixed costs typically incurred in terms of transaction charges (LAGA), or cost arising out due to electronic movement of shares through depository companies etc but is the cost attributable to the lack of market liquidity as explained subsequently in this article.
Liquidity comes from the buyers and sellers in the market, who are constantly on the look for buying and selling. Lack of liquidity translates into a high cost for buyers and sellers. Liquidity means transactions cost; a highly liquid market is one where large transactions can be immediately done without incurring much transactions cost.
So where does liquidity spring from? Many people in their own thoughts look towards big players, often pronounced as "market makers" as a major force beneath the liquidity. However, the anatomy of speculation suggests that a group of people/entities in the economy who wish to buy and sell are technically the ones who actually create liquidity for others. An individual market maker is a mere intermediary who facilitates the market, but he cannot create liquidity out of thin air.
The liquidity can be observed in the Market By Price (MBP) window of the KATS where the aggregate volume and number of orders in accordance with price levels for a symbol in the regular order book are displayed and updated on real-time basis whenever this information changes. The limit order books constitute the MBP dataset for a symbol.
KATS Limit Order Book (KATSLOB) is built of limit orders. People place limit orders with the intention to buy or sell, at a stated quantity and at a stated price. A limit order is a person who is saying "I'm willing to buy 100 shares at Rs 19 each". The limit orders are matched to generate trades, if mutually compatible, by the trading system. For example, when a computer finds another person saying "I'm willing to sell 100 shares at Rs 19 each", the interests of both buyer and seller are matched.
If a limit order cannot be matched immediately, it has to reside in the limit order book waiting for someone to hit on it. Hence, at any point in time, one can go to the market and look at the entire limit order book, and know the trading intentions of all others on the market.
The person who places a limit order obviously has the right (but not the obligation) to cancel the order, depending on the size of the market, the trading system release time and sales information relating to MBP and liquidity in the market. These information in small markets are in thousands, whereas in bigger markets, these turn out to be in millions. The KATS release over a million times and sales information in single trading session based on slight change in KATSLOB, and time and sales information reechoes on the KSE and LAN and all market participants instantly.
Traders can also place market orders buy or sell "at the best available price". Market orders are matched against the best available limit orders at that point in time. When a trader through TWS approaches the market with an intention to trade, the market possesses liquidity solely by virtue of limit orders which exist, and remains available for him to use them (KATSLOB). If he wishes to buy, he would hit on the existing limit orders of those who wish to sell, and vice versa. Given below is an example of an order book for one stock at some point in time which shows eight limit orders on the screen.
AN IMPORTANT FEATURE OF KATS IS ANONYMITY: ie, all that is seen are the prices and quantities that other traders are willing to trade at. The identities of the people placing these orders are not public. There is no room for coalition-forming, strategic games, and the cartels that afflict non-anonymous markets.
In this order book, there are four buy and four sell orders (their numbers do not always have to be equal). The distance between the best bid and the best offer (in this case, Rs 0.50/=) is called the bid-ask spread. If a person went into the market and tried to buy 100 shares, he would place a market order for 100 shares.
This would be matched by the computer against order No 5, the best available sell, and he would get the shares for Rs 4 each. If he tried to place a market order for selling 100 shares, the computer against order No 4 would match it, and the shares would be sold at Rs 3.5.
Hence a person buys 100 shares, and turns around to the market and immediately sells them off, he is poorer by the bid-ask spread. The spread is the transactions cost which the market charges anyone for the privilege of trading (at a transaction size of 100 shares). High liquidity at 100-share transactions is synonymous with tight spreads.
Suppose a person wants to buy or sell 3000 shares. The market order on the sell side will hit on orders No 4 and No 3, and the market buy order will hit on No 5 and No 6. The "bid-ask spread" is misleading insofar as it only conveys the prices faced in doing small trades; for larger trades, the prices faced would be quite different.
This brings us to the concept of impact cost. It is significant to understand the ideal price which is (3.5+4)/2, ie 3.75. In an ideal infinitely-liquid market, we would be able to do very large transactions on both buy and sell at prices which are very close to Rs 3.75. In reality, the market requires us to pay more than Rs 3.75 when buying and pays us less than Rs 3.75 when selling. The percentage degradation that is forced on us is called impact cost.
Impact cost varies with transaction size. For example, in the above order book, a transaction of selling 4000 shares goes through at Rs 3.4 costing 13,600 for 4000 shares. The difference of ideal cost (3.75) and shares actually transaction price is 0.35 which is 10.29% worse than the ideal price of Rs 3.75. Hence we say "The impact cost faced in buying 4000 shares is 10.29%".
Impact cost is a measure of market liquidity; it is closer to the true cost of execution faced by a user as compared with the bid-ask spread.
In a speculative transaction, a person buys, holds for some time, and then sells. Each leg of this transaction suffers an impact cost, so the speculator loses twice the impact cost (if the trade size was only 100 shares, the speculator loses the spread). Hence, speculative volumes are attracted to markets with low impact cost. As compared with the other costs involved in doing a speculative transaction (eg the 0.00x% stamp duty that Government is considering to impose against each electronic movement of shares), the spread for the most liquid stocks of the country may stretch bigger.
We should understand (a) that impact cost can vary between buy and sell, and can vary for every different transaction size and (b) impact cost fluctuates from moment to moment as traders change the limit orders that they have kept in the limit order book. However, at any instant point in time, the stock of orders waiting in the limit order book embodies the liquidity that exists on the market.
When the entire limit order book is observed, impact cost can be calculated at any desired transaction size.
For example, these numbers mean that in March 1995, a market order for Rs 2 million of UNBL faces an impact cost of 0.106% on average, but the same market order for HUBC faced an impact cost of 0.338% on average. Obviously, larger orders face a larger impact cost. A market where the entire order book is displayed is highly transparent about liquidity. The KATS TWS makes all limit orders publicly visible through MBO, MBS, and MBP so as to enable market participants to measure impact cost of a transaction even before the transaction takes place, and use this to help them decide whether to do the trade.
Liquidity can be likened to a developed society's judge who is akin to the substance only. Such a decision maker or judge would always consider UNILEVER as an illiquid stock as nobody ever in usual circumstances would offload UNILEVER, although the MBP may be full of bids, which in the norms of liquidity is subject to a penal cost. The way to distinguish between a symbols not being present in the one side of the order book on account of 'NO OFFLOADING' and not being there on account of really being illiquid remains a question to be answered.
(The writer is Deputy Chief Manager, Karachi Stock Exchange.)

=======================================================
          BUY SIDE ORDERS       SELL SIDE ORDERS
Order no Quantity   Price  Order no  Quantity     Price
=======================================================
4         1000       3.5      5        2000           4
3         2000       3.4      6        1000        4.05
1         1000       3.3      7         500         4.2
2         1000       3.3      8         100        4.25
=======================================================

=======================================================
Security     Rs 100,000     Rs 1000,000     Rs 2000,000
PTC             0.143          0.271              0.389
HUBC            0.125          0.245              0.338
ICI             0.122          0.218              0.289
PSO             0.099          0.162              0.209
LUCK            0.080          0.104              0.123
SSGC            0.078          0.102              0.118
UNBL            0.075          0.092              0.106
=======================================================