Liquidity definition

What is liquidity?

Liquidity is used in finance to describe how easily an asset can be bought or sold in the market without affecting its price – it can also be known as market liquidity. When there is a high demand for an asset, there is high liquidity, as it will be easier to find a buyer (or seller) for that asset.

Cash is considered the most liquid asset because it is very stable, can be readily accessed and easily spent. Therefore, cash is commonly used to gauge the liquidity of other markets. For example, the liquidity of a stock is measured by how quickly and easily it can be converted to cash. If it is difficult to convert an asset into cash, then it is considered illiquid.

One way to evaluate the level of market liquidity is by observing the bid/ask spread – as the liquidity of an asset increases, the bid/ask spread usually tightens.

Examples of liquidity

Liquid markets

In a liquid market it is easy to execute a trade quickly because there are numerous buyers and sellers. For instance, with a daily trading volume of over $5 trillion, forex is considered the largest and most liquid market in the world.

Large stock markets, such as the New York Stock Exchange, are also considered highly liquid because thousands of shares change hands every day. But the liquidity of an individual stock can vary depending on factors such as its market capitalisation, the exchange its shares are traded on and whether it is included on an index. Usually blue-chip stocks such as Microsoft, Google and Apple will be extremely liquid.

Illiquid markets

Illiquid assets cannot be easily bought or sold, due to a lack of willing investors or speculators. Some small-cap stocks are likely to have less liquidity when compared to equities with larger market caps, especially those that trade over-the-counter (OTC), as there is significantly less market interest.

Other examples of illiquid assets include real estate, some forex pairs – especially emerging FX pairs and exotic pairs – and smaller cryptocurrencies.

Pros and cons of liquidity

Pros of liquidity

If there is significant liquidity, traders can buy and sell assets rapidly at any time within market hours. This is often associated with reduced risk, as market participants can exit their positions quickly without a majorly impacting the asset’s price.

Apart from being accessible and generally easier to trade, liquid markets are also characterised by more stable prices and higher levels of efficiency.

Cons of liquidity

There are very few drawbacks of liquidity, in fact, there are typically more drawbacks associated with a lack of liquidity – known as ‘liquidity risk’.

If a market is illiquid, frequent and significant price movements can occur because the supply and demand of the traded security is low. Buyers and sellers may find they have to go to multiple parties, potentially with different prices, in order to get their order filled in their intended size.