Does transparency impact market liquidity? : evidence from the European Union and United States equity markets

We find evidence for increased market transparency to have a positive effect on equity market liquidity. Using data from EU and US equity markets, we estimate the effect of the implementation of the Markets in Financial Instruments Directive to increase liquidity in EU stock markets. To measure different dimensions of market liquidity we use bid-ask spreads, the percentage daily range, the Hui-Heubel liquidity ratio, the Market Efficiency Coefficient, trading volume and Amihud’s Illiquidity ratio. These metrics are used to measure the tightness, immediacy, breadth, resiliency, depth, and general liquidity of the market, respectively. We use a staggered Difference-in-Difference analysis to estimate an increase in all liquidity dimensions except immediacy, which decreases. This provides evidence for a positive relationship between market transparency and liquidity, but also suggests that the increase in some liquidity dimensions may come at the expense of others. However, for some of the liquidity metrics it is doubtful whether the parallel trends assumption holds, which limits the causal interpretation of these findings. The results should therefore be interpreted with caution. Although we do not provide a conclusive answer regarding the mechanisms through which transparency affects liquidity, we argue that the positive liquidity effects likely come as transparency lowers risk for price-setting market makers while also causing traders to change their strategies in ways that are conducive to liquidity