Liquidity is a measure of market participants’ ability to trade what they want, when they want, at a mutually agreed upon price for a specific quantity. As such, adequate liquidity is an essential component of market health. Liquid markets ensure that market participants can efficiently hedge and transfer risk, businesses can easily raise capital, and investors can optimize growth.
In the simplest model of a trade, a seller would show up willing to sell a certain quantity and price, and a buyer would appear at the same time, wanting to buy that quantity for that price. Markets would be perfectly liquid because supply would always meet demand in a timely fashion.
But what if the buyer is ready to purchase a week before the seller commits to selling? Or if the seller can only find someone to purchase half of what he needed to sell? Without liquidity providers – firms willing to take the other side of a trade, buyers and sellers would face a long wait before connecting with a counterparty. Alternatively, buyers may be forced to pay higher prices (or sellers may be forced to sell at a discount) in order to make a trade in a timely fashion.
A market’s level of liquidity is indicated by a variety of factors. For instance, a highly liquid market has a small bid/ask spread because there is relatively high supply and demand for a product, which fosters price competition. The outcome? Buyers and sellers don’t have a large gap between the lowest sell price and the highest buy price. A liquid market will also have a relatively high number of participants and a deep order book, with a number of open buy and sell orders at different prices. A deeper book means that prices won’t move dramatically when large buy or sell orders are entered into the market. A higher traded volume also indicates a more liquid market, with buyers and sellers making frequent trades. Finally, a relatively balanced order book is also indicative of a liquid market, with an even demand from buyers and sellers.
An example of a highly liquid market is easy to imagine: consider Apple’s stock. The market for it is easy to access, the stock is frequently traded, and it features low bid/ask spreads, high trade volumes, and a deep and balanced order book. Consider, on the other hand, the market for real estate in some distressed locations at the height of the financial crisis. The bid/ask spread was huge, as homeowners wanted to sell their house at or near the price they paid for it, while buyers, such as there were, wanted a steep discount. Actual traded volumes were low, as many people simply abandoned their homes. And the order book was dramatically unbalanced with a high ratio of sellers to buyers. Now, as these same locations become revitalized, the real estate market is slowly becoming more liquid.
Because of its importance, liquidity has been a hot topic among regulators and market participants recently. This is a critical discussion and FIA PTG is committed to promoting a productive dialogue about liquidity. To that end, we will be publishing a series of blogs in which we address factors that influence liquidity, including the role of liquidity providers, the importance of diverse liquidity provision, structural issues that impact liquidity, and the ways in which liquidity providers operate in different asset classes.