Increasing returns to liquidity in futures markets

A simple model, based on the binomial theorem, is employed to predict that the probability of matching buyers and sellers increases with the number of transactions. The ask-bid spread, interpreted as a measure of liquidity, is assumed to vary negatively with the probability of matching buyers and sellers. The hypothesis addressed in this paper is that the ask-bid spread varies negatively with volume. This hypothesis is investigated for six contracts traded on the Sydney Futures Exchange from 1980 to 1991. The results support the hypothesis for the majority of contracts studied. The implication of these results is that futures trading can be expected to become concentrated geographically in a few key locations, and within exchanges in a few key contracts.