Category Archives: MarketReg Advisors

[O]ne significant contribution to a market’s liquidity may be a market with heterogeneous participants with respect to strategic intentions for trading. Additionally, markets may be more liquid when participants have heterogeneous information sets (i.e., having heterogeneous views of what information is salient and heterogeneous interpretations of public information). Conversely, one cause of illiquidity may be when market participants’ strategic intention sets or information sets become more homogenous, and/or when traders with heterogeneous strategy or information sets increasingly avoid trading.

In other words, although they are usually buying and selling the same securities, local and foreign participants may be guided by divergent motivations that make them willing to trade against each other even though they all have the same information.  Foreign exchange rate fluctuations, for example, may induce foreign investors to sell because it reduces their IRR, even as local investors see a buy opportunity because the new exchange rate promises a favorable benefit to a local listed company.  Or the foreign investor may be liquidating a position in one country to take advantage of an opportunity in another, while local participants are limited by regulation or resources to stay in the local market.  In either case, their strategies are incommensurable; they can’t be described as either “following the herd” or “separating the fools from their money.”  They’re just playing different games.

The point here is that regulations and policies that encourage participation by players with heterogeneous motivations may promote liquidity, because it increases the likelihood that rational participants will meet as counterparties.  Market operators and apex regulators looking to improve liquidity in a local market should therefore consider steps they can take to create the conditions for heterogeneous motivations, whether through loosening barriers to foreign direct investment, or promoting local regulations that will shift the motivations of local participants.