Financial market practitioners frequently observe that market liquidity decreases when a bout of heightened volatility confronts markets. The inverse relationship between volatility and liquidity is evident and logical for tradeable products when one considers prudent risk management requirements of liquidity providers. Highly liquid benchmark futures products at CME Group are no exception. Indeed, commentators reported the reduced book depth and the widening of effective bid/ask spreads in E-mini S&P 500 (ES) futures in January 2022 at the same time that volatility reached multi-year highs.

Over the long term, it is relatively easy to lose sight of the fact that equity indexes have traversed a very broad trading range in recent years. This broad price range does have an impact on the perceived liquidity if one only considers the number of contracts on bid and offer in the order book.

To illustrate, one can consider two distinct points in time at which the S&P 500 Index was at 2,000 and 4,000 points, respectively. With a multiplier of $50 per contract, the ES futures would have, correspondingly, notional value of $100,000 and $200,000.

Since the trading tick of 0.25 index points is invariant to the level of the index, the tick size is 1.25 and 0.625 basis point of notional value when the index was at 2,000 vs. 4,000. Thus, in notional terms, the tick size at the index level of 4,000 is one half of that at the index level of 2,000. At the same time, each contract on bid/offer at the index level of 4,000 is twice as large in notional value when compared to the latter. One could readily conclude that it would not be helpful to simply look at the top of the book quantity to judge liquidity, especially over the long run.

Accounting for the effects of the notional value changes, the graphs in Figure 1 provide a longer-term liquidity perspective on the ES futures market. The four panels of Figure 1 show the round-trip cost to trade for ES contracts at a notional size of $1, $5, $10 and $25million (blue lines) as well as the number of ES contracts to achieve the notional size (orange lines).

As the index value increases over time, the number of ES contracts to achieve each fixed notional value decreases. From the upward spikes of the orange lines, one can also deduce when the market exhibited substantial corrections. The most prominent example was certainly that of the March 2020 episode, when the market was dealing with market turmoil associated with the COVID-19 pandemic and the corresponding economic impact of lockdown measures.

The round-trip cost to trade (CTT) associated with the four fixed trade sizes all exhibited the expected slow downward trend due to the fixed tick size in the ES market. For example, over the 5-year period depicted in the graphs, the CTT for a $25million trade in ES was in the range of 1 to 1.5 basis points, with occasional spikes.

The spikes in the CTT lined up with the market turmoil indicated by the spikes in the orange lines, with the most prominent impact to liquidity recorded during in March 2020. Indeed, that was the only episode within the 5-year period in which the equity market circuit breaker rules had been triggered . 

Figure 1. Cost-to-Trade measure of CME E-mini S&P 500 futures – front-month contract, with notional trade size of $1m

Figure 2. Cost-to-Trade measure of CME E-mini S&P 500 futures – front-month contract, with notional trade size of $5m

Figure 3. Cost-to-Trade measure of CME E-mini S&P 500 futures – front-month contract, with notional trade size of $10m

Figure 4. Cost-to-Trade measure of CME E-mini S&P 500 futures – front-month contract, with notional trade size of $25m

Legend – blue line: immediate round-trip cost to trade measured in basis points (left vertical axis); orange line: number of front-month E-mini S&P 500 futures to achieve notional size of trade (right vertical axis)

The translation of the liquidity into these CTT measures put the January 2022 market liquidity performance into perspective:

While the smaller trade sizes have not seen very significant impact, the CTT visibly increased for larger trades. For example, a $25million trade increased from a round-trip cost of sub-1 basis point in 2021 to over 2 basis points during the spike.

Cost to trade on a notionally adjusted basis was comparable, or even lower, during the heightened volatility period of January 2022 versus similar episodes in previous years.  The perceived liquidity crunch was far from outsized in relation to similar events in the recent past. The graphs also confirm another important observation – that market liquidity tends to be restored quickly following volatility events. Rather than the CTT measure plateauing at a higher level after the shocks, it quickly reverted to the trend levels.

Interested readers are encouraged to investigate how the methodology behind CTT measures works). CTT data is available via CME Liquidity Tool as well as CME DataMine.

Please contact James Boudreault CFA, Mohandas Ayikara, and Richard Co for questions about this article.

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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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