What is liquidity?

What is liquidity?

While difficult to measure explicitly, liquidity is often measured in terms of, and has a tight correlation with, trading volumes in any particular market – higher volumes, and therefore a greater number of market participants, typically leads to greater market liquidity, with the opposite being true of markets with lower volumes.

A market falling into the latter category could be described as being ‘illiquid’, with markets displaying high levels of liquidity considered ‘liquid’.

The importance  of liquidity

There are numerous reasons why liquidity is important. Primarily, however, it is a key factor for traders as the degree of liquidity that a market possesses directly impacts the speed with which liquid assets can be turned into cash, and vice versa. In other words, liquidity directly influences how quickly a trader can open, and close, their positions.

A relationship also exists between liquidity and risk. Highly liquid financial markets would generally be considered less risky than illiquid ones, given that, in such  markets, it is both quick, and easy, to enter and exit positions, with ample other market participants willing to take on the other side of a trade. Furthermore, this is likely to occur without too significant a move in price, meaning that orders will likely be filled at, or close to, the trader’s desired level.

As a result, the more liquid the market the more popular a market it will likely be to trade, given that market participants tend to be attracted to current assets where they are able to simply, and rapidly, open and close positions at will. This can create the effect of a virtuous cycle, whereby greater market liquidity encourages an increased number of traders to participate in a specific current asset, thus further improving the liquidity of said market.

It's also important to consider the impact of liquidity on price. A higher degree of liquidity implicitly means a greater number of pending orders on both sides of the market underlying a CFD or spread bet contract. Consequently, this increases the chances of the highest bid and lowest ask price being closer together, resulting in a tightening of the bid-ask spread. This, in turn, translates directly into a tighter spread being passed through to those trading leveraged products. That being said, Liquidity risk is not the only risk you will need to consider when trading.

What are the most liquid markets?

As mentioned previously, the most liquid markets are typically those with the highest number of participants engaging with them. However, before covering which assets and instruments tend to be the most liquid, it’s important to note that the most liquid asset of them all is cash, given that, of all assets, it is the one that can most quickly and easily be converted into anything else.

When examining tradable assets, the foreign exchange market is noted for its exceptional liquidity, chiefly on account of its immense dimensions. In 2022, the daily global FX turnover surged to $7.5tln, as per the triennial BIS survey, a figure largely influenced by the actions of central banks. This massive volume results from, and in turn engenders, a wide spectrum of market participants in the FX market. Central banks are once more involved, alongside governments, massive corporate and institutional flows, speculative traders, and even individuals swapping currency in anticipation of an international trip.

There are, however, some caveats when it comes to the FX market. Not all currency pairs are as liquid as others, with G10 currencies, in addition to some frequently traded crosses such as EUR/USD and EUR/JPY, by far the most traded, and most liquid, areas of the market. It must be said that, despite overall being one of the most liquid asset classes, there are areas of the FX market – emerging and frontier markets spring to mind – where liquidity is significantly poorer.

Other examples of highly liquid markets include large-cap equities, typically those companies with a market cap greater than $10bln, and commodity futures, such as those derived from crude oil and gold, which have turned a once illiquid physical marketplace into one of the world’s most liquid, and important, financial markets.

What causes illiquidity?

Perhaps unsurprisingly, illiquidity is caused by the opposite factors that create a liquid market – namely, a market which has light trading volumes, and few participants.

There are two notable implications of an illiquid market. Firstly, an illiquid market often increases the time it takes to execute trades, given that one would likely need to wait a longer period of time for an order to be filled at the desired price.

The second implication stems from the above, in that, rather than waiting for a pending order to be filled, one may instead want to open or close a position immediately. In this scenario, rather than paying in terms of the waiting time to be filled on an order, a trader pays a direct cost, either via a wider spread to immediately execute the trade with a market maker and transfer the risk to their side, or by moving the price of the order to ensure a quicker fill.

In both situations, an illiquid market increases both the friction and costs involved with trading.

Pros & cons of liquidity

As noted, there are numerous advantages to liquid markets, chiefly in terms of the ease with which trades can be executed, in size, on a cost effective basis, at a rapid pace. Generally, the more liquid a market is, the easier it therefore is for traders to rapidly buy and sell said asset, without significantly impacting its price.

Taking all this into account, more liquid markets are typically considered as more efficient markets, meaning that the price seen on the screen is significantly more likely to accurately reflect all available and relevant information at a given time.

Unsurprisingly, there are few, if any, drawbacks to liquid, and efficient markets. One should, however, consider the concept of liquidity risk when discussing liquidity as a broader theme. This is a risk that occurs when an asset cannot be sold when desired due to a lack of liquidity in the market, either due to a scarcity of volume, and/or a sharp widening of the bid ask spread. Traders taking positions in less liquid, and more exotic, assets should bear this in mind while trading.