What is “Liquidity Begets Liquidity”?

Simply put, the phrase “Liquidity Begets Liquidity” means that once a marketplace is proven to have trading activity, more is bound to follow. On a more nuanced level, the phrase refers to a virtuous cycle between makers and takers:

1. A willingness of buyers & sellers to transact in a patient manner creates liquidity.

2. The existence of liquidity attracts takers due to their ability to trade efficiently with minimal market impact.

3. An increase in order flow from uninformed takers presents more attractive opportunities for liquidity providers to capture the bid-ask spread (i.e., buy low and sell high simultaneously), thus allowing them to generate more lucrative profit.

4. Profit-seeking makers then increase the size and resilience of their quotations, thus further improving liquidity on order books, which in turn attracts more takers.

See below for an illustration of “Liquidity Begets Liquidity.”

Recall that each individual in a marketplace is self-interested. Neither makers nor takers in the virtuous cycle of “Liquidity Begets Liquidity” trade with the intention of benefiting the other side. Neither makers nor takers actively want to lose in the zero-sum game that is trading. Even so, the actions of each side create a self-enforcing feedback loop which ultimately creates more and more marketplace activity. Equipped with our knowledge of basic motivations in market microstructure, we can clearly analyze the self-interested actions that fuel the virtuous cycle of “Liquidity Begets Liquidity.”