What is market liquidity?
Market liquidity refers to how quickly security, currency, or commodity can be bought and sold in a financial market without negatively affecting its price.
Market liquidity is to be discerned from accounting liquidity.[1]
What is a liquid market?
Generally speaking, a liquid market refers to any type of financial market which is always available and in which an asset can easily be traded without a significant fluctuation in its price.
Cash is regarded as the most liquid asset because it is to a great extent stable, readily available, and can easily be spent. Hence, cash is usually used to measure the liquidity of a financial market. For instance, the liquidity of the shares of a company is determined by how easily and quickly they can be converted to cash.
The particulars of what defines a liquid market may vary, depending on the type of asset being traded.
Normally, liquidity is measured by considering the volume of trades, or the number of trades pending, currently on a particular financial market.
Features of a liquid market
Typically, a liquid market comprises, amongst others, the following features:
- Assets can be easily converted into cash without significant price fluctuations, and with a minimum amount of decline in value.
- A considerable level of trading activity with both high supplies of and demands for assets, implying there are numerous buyers and sellers executing trades.
- The market spread remains relatively small. This means that notwithstanding daily fluctuations in supply and demand, the gap between the price at which sellers are willing to sell an asset and the price that buyers are willing to buy the asset stays relatively small.
- Comparatively low transaction costs.
- Large numbers of sellers and buyers are ready and prepared to execute trades at any time during the trading hours of a financial market.
The most liquid markets
As mentioned, cash, as the most liquid asset, is usually used as a standard to gauge the liquidity of most other assets, discerning how promptly and effortlessly they can be converted into cash.
Analysts agree that the forex market succeeds cash as the most liquid market. However, there is a difference of opinion between financial analysts about the sequence of the most liquid markets after the forex market.
Some analysts have listed guaranteed investment certificates (GICs), government bonds, corporate bonds, publicly traded shares, and commodities on their preferred list. Contrarily, other analysts choose shares of companies with large market capitalisations (large-cap shares or stocks), and commodities.
This article will briefly focus on the forex market, large-cap companies, and commodities.
The forex market
The forex market, also referred to as the foreign exchange or currency market, is a decentralised financial market, encompassing a network of traders that trade electronically worldwide. Notable traders in the market are, amongst others, central banks, investment banks, commercial banks, and other large financial institutions.
The forex market is the largest and most liquid financial market in the world, with a daily trading volume of about 6,5 trillion dollars.
Most of the trading includes the seven major currency pairs: The Euro/US Dollar (EUR/USD), the British Pound/US Dollar (GBP/USD), the US Dollar/Japanese Yen (USD/JPY), the US Dollar/Canadian Dollar (USD/CAD), the Australian Dollar/US Dollar (AUD/USD), the US Dollar/Swiss Franc (USD/CHF), the New Zealand Dollar/US Dollar (NZD/USD).
The higher the volume of the forex market, the greater the liquidity. The forex market is exceptionally liquid, due to a large number of traders at any given time.
Liquidity boosts the trading of currencies, leading to tighter spreads, and lower transaction costs.
However, the high levels of liquidity do not manifest steady pricing in the forex market. Different opinions about what the price of a major currency pair should be, lead to daily price fluctuations, creating high levels of volatility. Nonetheless, currency prices are usually kept within a trading range and are traded in smaller increases.
Liquidity in the forex market is important for various reasons, such as:
- The tendency to reduce the risk of slippage which is most prevalent during times of higher volatility. (Slippage refers to the difference between a trade’s expected price and the price at which the trade is eventually executed.)
- Enables faster execution of orders.
- Provides narrow bid-offer spreads.
Stock exchanges trading shares of companies with large market capitalisations
The market capitalisation (market cap) of a company refers to the total market value (expressed in the currency of a particular country) of a company’s outstanding shares. The market cap is calculated by multiplying the current market price of one share of a company with the total number of a company’s outstanding shares.
Typically, shares of companies with large caps tend to have stable prices and high volumes of trades which makes them highly liquid, implying that the shares can be converted into cash relatively swiftly.
Commodities markets
Commodities are tangible goods, so-called hard assets, that are interchangeable (bought, sold, or exchanged) with products of the same type and similar value.
The trading possibilities created by derivative products, such as Exchange Traded Funds (ETFs), Contracts for Difference (CFDs), and futures enhance trades in commodities. Consequently, the liquidity of many commodities has improved, because the more frequently a commodity is traded, the more liquid it becomes.
The most liquid commodities markets are:
- Crude oil.
- Gold.
- Coffee.
- Sugar.
Illiquid markets
An illiquid market can be described as a financial market in which an asset is traded that cannot quickly and easily be converted into cash without a considerable loss in value.
Reasons for illiquid markets are, inter alia, a lack of interested market participants and the type of asset.
Examples of illiquid markets include companies with low market capitalisations, real estate, art, luxury items, and exotic currency pairs, comprising a major currency and the currency of an emerging or developing market, such as the South African rand (ZAR).
Importance of liquid markets
There are numerous reasons that can be mentioned to emphasise the importance of liquid markets. To mention a few, liquid markets:
- are generally characterised by high levels of efficiency and stable prices,
- tend to minimise the degree of price fluctuations of assets,
- reduce trade risks because there will always be willing buyers and sellers.
[1] Refer the article, ‘Liquidity in Accounting Explained for Dummies’, for a detailed explanation of accounting liquidity.
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