Market liquidity refers to the speed at which an asset or security can be converted into another without significantly reducing it’s intrinsic value, created either by transaction costs or by reducing the item price. Cash is considered to be the most liquid asset, since it can be readily exchanged for other assets, a process which we know as buying and selling.
When a business goes bankrupt, it’s assets are sold off to pay existing debts, and this process is known as liquidation.
Assets such as corporate bonds, real estate, fine art, and collectibles are relatively illiquid. To sell an illiquid asset either requires waiting for the right buyer to appear and purchase the asset which may take time, or reducing the asset price if the seller needs the money quickly. Thus, liquidity is a trade-off between the selling period and the final purchase price.
Liquidity is important in the markets because it determines the difficulty that assets can be bought or sold quickly, and at what stable prices. Put simply, it is a measure of how many buyers and sellers are in the market, and this directly impacts on the asset spread (the difference between the purchase and selling prices of the asset).
Highly liquid markets such as the foreign exchange (forex) markets are low risk. With five trillion US dollars traded on the market every day, it is much easier to find buyers and sellers willing to take the opposite sides of your transactions and consequently, the spread is much tighter. Popular currency pairs such as EUR/USD, GBP/USD and USD/JPY experience high liquidity.
Illiquid markets have much higher risk. It is more difficult to find buyers and sellers for an asset. Thus, the spread is wider: it will cost more to purchase the asset and it is more likely that the asset will be sold at a reduced price. The width of the spread and the liquidity of the market must always be considered when trading the financial markets.
Liquidity refers to the amount of market interest (the number of active traders and the overall volume of trading) present in a particular market at any given time. From an individual trader’s perspective, liquidity is usually experienced in terms of the volatility of price movements. A highly liquid market will tend to see prices move very gradually and in smaller increments. A less liquid market will tend to see prices move more abruptly and in larger price increments.
Forex market liquidity will vary throughout each trading day as global financial centers open and close in their respective time zones. Reduced liquidity is first evident during the Asian trading session. Japanese data or comments from officials may provoke a larger-than-expected or more persistent reaction simply because there is less trading interest to counteract the directional move suggested by the news.
Peak liquidity conditions are in effect when European and London markets are open, overlapping with Asian sessions in their morning and North American markets in the European afternoon. Following the close of European trading, liquidity drops off sharply in what is commonly referred to as the New York afternoon market.
During these periods of reduced liquidity, currency rates are subject to more sudden and volatile price movements. The catalyst could be news events or rumours, and the reduced liquidity sees prices react more abruptly than would be the case during more liquid periods.
There’s no way to predict with any certainty how price movements will develop in such relatively illiquid periods, and that’s the ultimate point in terms of risk. The bottom line is that if you maintain a position in the market during periods of thin liquidity, you’re exposed to an increased risk of more volatile price action.
Liquidity is also reduced by market holidays in various countries and seasonal periods of reduced market interest, such as the late summer and around the Easter and Christmas holidays.
Typically, holiday sessions result in reduced volatility as markets succumb to inertia and remain confined to ranges. The risks also increase for sudden breakouts and major trend reversals. Aggressive speculators such as hedge funds exploit reduced liquidity to push markets past key technical points, which forces other market participants to respond belatedly, propelling the breakout or reversal even further. By the time the holiday is over, the market may have moved and established an entirely new direction.
Whilst low liquidity suppresses financial markets, high liquidity encourages trade and stimulates the economy. When economies have insufficient funds to encourage trade, central banks can step in by purchasing assets from commercial banks, providing them with enough money to lend and stimulate the economy. This lowers interest rates and increases the money supply. However, when short-term interest rates are at or approaching zero, normal open market operations that target interest rates are no longer effective.
If central banks do not have enough money to purchase assets, they can also use an alternative strategy called Quantitative Easing (QE). Central banks can literally create money out of thin air (‘ex nihilo’ to use the Latin term) and with just a few clicks on a computer keyboard, Hey Presto! billions and billions of pounds are instantaneously created.
The central banks can then purchase a preset amount of assets from commercial banks, providing them with enough liquidity to stimulate the economy. With more money chasing the same number of goods and services, the economy might be at risk of higher inflation. Yet, provided QE is done carefully, the economy can expand to accommodate this increased cashflow and the inflationary risks are mitigated causing inflation rates to remain stable.
Other resources relating to liquidity and financial capital.
