Exploring the dynamics of market liquidity

The dissertation explores the dynamics of market liquidity, acknowledging its importance in modern finance. Market liquidity operates across various scales, with its significance spanning from the micro to the macro level. At the micro level, market liquidity embodies the (measurable) price of immediacy, influencing the ease with which assets can be converted into cash and vice versa. Conversely, on a macro scale, it presents itself as an abstract impediment, hindering the attainment of efficient market equilibria. Positioned between these two extremes lies the domain of asset pricing, where market liquidity manifests itself as a liquidity premium— a distinct asset specific property. Recognizing the facilitating role of market liquidity in enhancing economic prosperity and welfare, the dissertation undertakes an investigation into its underlying mechanisms. While dealer inventory constraints and the presence of (asymmetric) information are believed to be the primary structural drivers of market liquidity, this research explores three of ancillary mechanisms that play a role in the formation of market liquidity: market making incentives, the presence of dynamic hedgers, and order monitoring costs The core of this dissertation comprises three principal chapters. Firstly, it examines the interaction between primary and secondary markets for Euro area government bonds, demonstrating a significant relationship between expected primary issuance fees and market liquidity. The formation of market liquidity is shown to be affected by the institutional setting. Secondly, this thesis explores the impact of the gamma positioning of dynamic hedgers on market quality, revealing the effects of gamma positioning on liquidity, price discovery, volatility and stability. In the final principal chapter, the effect of order monitoring costs as a fundamental driver of liquidity is investigated, highlighting the asymmetric effects of order monitoring costs and its implications on overall market quality. In conclusion, through empirical investigations and agent-based modelling, a new set of drivers that shape market liquidity is scrutinized, offering new perspectives on the dynamics of market liquidity. These insights provide a basis for further research and yield potential policy instruments that could be harnessed to enhance market liquidity.