Liquidity, in one sense, refers to how easily one can get into or out of an investment in a financial instrument (e.g., securities, futures contracts, options, bonds, etc.). In an illiquid market, sellers cannot easily find buyers. When that happens, investment risk can be high because sellers cannot get their money out of their investments easily. A liquid market also tends to have better price stability and increased overall order volume because issuers, investors and market participants typically seek out the most liquid marketplaces.
As a result, market centers, such as securities exchanges, try to make the most liquid market possible. One way market centers attempt to generate market liquidity is through market makers. Market makers are firms or individuals who “make markets” in a financial instrument by quoting the prices at which they are willing to buy or sell that financial instrument. These price quotes—bids and offers (or “bids and asks”)—are published to the investing community via the various data feeds put out by the market centers where the given market makers operate. When investors or their agents check the price quotes and decide to make a trade, the market maker for that security will generally guarantee to buy or sell at least some of the shares at the published price. Because market makers are willing to take on risk themselves and follow through on published bid or ask prices, they can provide liquidity to the marketplace.
The key to a market maker's ability to generate liquidity and bring these benefits to the marketplace is its ability to make effective quotes and trades. Every market center's goal, and as such every market maker for that market center's goal, is to post the highest bid and lowest offer (e.g., the “inside” market) in the entire marketplace so they can consistently execute orders and provide the most liquidity. At any given moment, the best price across all market centers is the market best bid (“Market Best Bid”) or market best offer (“Market Best Offer”). Therefore, every market center, and every market maker associated with that market center, wants to be setting the Market Best Bid and Market Best Offer (or trading very near those prices) as often as possible.
Though every market center and market maker wants to be at the Market Best Bid and Market Best Offer, there is presently no effective way for a market center, a market maker or an investor to assess how often a market center, a market maker or any other market participant is at the inside market and, therefore, no effective way to gauge a market center's liquidity or market maker's ability to generate liquidity in a market.
Accordingly, there is a need for a market liquidity analysis system and method that allows interested persons to monitor, collect and analyze a market center's, a market maker's or any market participant's trading activity to measure liquidity or to assess such entity's or individual's role in generating liquidity.