The Budapest Stock Exchange developed the Budapest Liquidity Measure in 2005 based on internationally recognised methodology. The measure quantifies different dimensions of market liquidity of traded instruments.
The BLM describes liquidity from the most important point of view of investors: it quantifies the implicit costs of the execution of an order when investors face less liquid markets. Therefore, the more liquid an instrument, the lower the BLM value, which means lower price paid for liquidity (lower implicit costs).
A market provides real liquidity if an order of any size can be immediately executed at any time without having significant market impact.
In many cases market shocks and crises take a form of liquidity crisis when prices are falling sharply because order books dry up and investors can only close their positions by creating huge negative market impact. Therefore, there is substantial practical relevance of liquidity measures today:
Retail investors - Liquidity measures enable to make more thorough investment decisions and to choose between different assets and markets by reducing risks and costs. Liquidity measure is also a great tool to develop trading strategies.
Issuers – Liquidity measure helps to compare the effectiveness of different secondary markets of their securities.
Institutional investors and brokerage firms – Liquidity measure can be used to analyse liquidity, manage portfolios' liquidity risk, develop new trading techniques, define the parameters of execution algorithms and analyse the transaction costs.
The BLM quantifies the costs of liquidity based on the state of the order book of the traded securities. A snapshot is taken of the order book at every second. Based on that average prices are calculated at which orders of different sizes could be executed. Orders of higher value can divert average price more, thus resulting in higher implicit costs and BLM values.
BLM consists of two parts:
Liquidity premium (LP): Measured by the bid-ask spread , paid by the investors after each transaction no matter how large the order size is;
Adverse price movement (APM): Orders of large value can not be executed at the best market price, therefore part of the bid or ask quantity will be executed at worse price levels. In this case the average execution price of the order will be less favourable than the best market price in the original order book. That is what we call the adverse price movement in case of larger order sizes.
BLM is calculated as the sum of the two factors above, the bid-ask spread and the total roundtrip market impact.
Chart 1: Dimensions of the Budapest Liquidity Measure*
*The BLM is calculated not just for the best five price levels but for all the price levels where any quantity is available.
Source: BSE, Deutsche Börse AG
The BLM is calculated in basis points simultaneously for five different order sizes: EUR 20,000, EUR 40,000, EUR 100,000, EUR 200,000 and EUR 500,000. It indicates the indirect cost of a transaction due to the above mentioned two factors. A snapshot is taken of the order book at every second and average BLM values can be calculated for longer time periods.
Interpretation of the BLM
The more liquid a security is the tighter and deeper its order book should be which result in lower BLM values. For example a value of 100 basis points (1%) for BLM (EUR 500,000) means that the immediate execution of a buy order for EUR 500,000 and the immediate execution of a sell order for the same size of the same security will result in 1% less favourable average execution price for the client compared to the mid-point price (the middle of the bid-ask spread). This 1% is also called the implicit transaction cost, while an example for explicit transaction cost is brokerage fee.
Example for the interpretation of BLM values: if the BLM equals to 50 bps (0.5%) and the order size is EUR 20,000, then a good estimation of the implicit cost of the transaction, which the investor has to take into account besides the brokerage fee, is EUR 100. That is the result of an investor not being able to open a position of EUR 20,000 at the mid-point price in the beginning of the trading day and then closing it at the mid-point price by the end of the day. The implicit cost of failing to execute at mid-point price reduces the profit of the transaction
Publication of BLM data
Statistics of monthly average bid-ask spread and BLM values for different order sizes are available for equities’, investment fund notes’, certificates’ and BUX futures’. More detailed database can be purchased through the information centre of the BSE.