business Business is the practice of making one's living or making money by producing or Trade, buying and selling Product (business), products (such as goods and Service (economics), services). It is also "any activity or enterprise entered into for ...

economics Economics () is a behavioral science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services. Economics focuses on the behaviour and interac ...

investment Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...

, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an

asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can b ...

without causing a drastic change in the asset's price. Liquidity involves the trade-off between the price at which an asset can be sold, and how quickly it can be sold. In a liquid market, the trade-off is mild: one can sell quickly without having to accept a significantly lower price. In a relatively illiquid market, an asset must be discounted in order to sell quickly. A liquid asset is an asset which can be converted into

cash In economics, cash is money in the physical form of currency, such as banknotes and coins. In book-keeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-i ...

within a relatively short period of time, or

itself, which can be considered the most liquid asset because it can be exchanged for

goods and services Goods are items that are usually (but not always) tangible, such as pens or Apple, apples. Services are activities provided by other people, such as teachers or barbers. Taken together, it is the Production (economics), production, distributio ...

instantly at face value.

Overview

A liquid asset has some or all of the following features: it can be sold rapidly, with minimal loss of value, anytime within market hours. The essential characteristic of a liquid market is that there are always ready and willing buyers and sellers. It is similar to, but distinct from,

market depth In finance, market depth is a real-time list displaying the quantity to be sold versus unit price. The list is organized by price level and is reflective of real-time market activity. Mathematically, it is the size of an order needed to move th ...

, which relates to the trade-off between quantity being sold and the price it can be sold for, rather than the liquidity trade-off between speed of sale and the price it can be sold for. A market may be considered both deep and liquid if there are ready and willing buyers and sellers in large quantities. An illiquid asset is an asset which is not readily salable (without a drastic price reduction, and sometimes not at any price) due to uncertainty about its value or the lack of a market in which it is regularly traded. The mortgage-related assets which resulted in the

subprime mortgage crisis The American subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010, contributing to the 2008 financial crisis. It led to a severe economic recession, with millions becoming unemployed and many busines ...

are examples of illiquid assets, as their value was not readily determinable despite being secured by real property. Before the crisis, they had moderate liquidity because it was believed that their value was generally known.

Speculators In finance, speculation is the purchase of an asset (a commodity, goods, or real estate) with the hope that it will become more valuable in a brief amount of time. It can also refer to short sales in which the speculator hopes for a decline i ...

and

market maker A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the difference, which is called the ''bid–ask spread'' or ''turn.'' Thi ...

s are key contributors to the liquidity of a market or asset. Speculators are individuals or institutions that seek to profit from anticipated increases or decreases in a particular market price.

Market maker A market maker or liquidity provider is a company or an individual that quotes both a buy and a sell price in a tradable asset held in inventory, hoping to make a profit on the difference, which is called the ''bid–ask spread'' or ''turn.'' Thi ...

s seek to profit by charging for the immediacy of execution: either implicitly by earning a bid/ask spread or explicitly by charging execution commissions. By doing this, they provide the capital needed to facilitate the liquidity. The risk of illiquidity does not apply only to individual investments: whole portfolios are subject to market risk. Financial institutions and asset managers that oversee portfolios are subject to what is called "structural" and "contingent"

liquidity risk Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price. Types Market liquidity – An asset cannot be ...

. Structural liquidity risk, sometimes called funding liquidity risk, is the risk associated with funding asset portfolios in the normal course of business. Contingent liquidity risk is the risk associated with finding additional funds or replacing maturing liabilities under potential, future-stressed market conditions. When a

central bank A central bank, reserve bank, national bank, or monetary authority is an institution that manages the monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the mo ...

tries to influence the liquidity (

supply Supply or supplies may refer to: *The amount of a resource that is available **Supply (economics), the amount of a product which is available to customers **Materiel, the goods and equipment for a military unit to fulfill its mission *Supply, as ...

) of money, this process is known as

open market operation In macroeconomics, an open market operation (OMO) is an activity by a central bank to exchange liquidity in its currency with a bank or a group of banks. The central bank can either transact government bonds and other financial assets in the ope ...

Effect on asset values

The market liquidity of assets affects their prices and expected returns. Theory and empirical evidence suggest that investors require higher return on assets with lower market liquidity to compensate them for the higher cost of trading these assets. That is, for an asset with given cash flow, the higher its market liquidity, the higher its price and the lower is its expected return. In addition, risk-averse investors require higher expected return if the asset's market-liquidity risk is greater. This risk involves the exposure of the asset return to shocks in overall market liquidity, the exposure of the asset's own liquidity to shocks in market liquidity and the effect of market return on the asset's own liquidity. Here too, the higher the liquidity risk, the higher the expected return on the asset or the lower is its price. One example of this is a comparison of assets with and without a liquid secondary market. The liquidity discount is the reduced promised yield or expected return for such assets, like the difference between newly issued U.S. Treasury bonds compared to off the run treasuries with the same term to maturity. Initial buyers know that other investors are less willing to buy off-the-run treasuries, so the newly issued bonds have a higher price (and hence lower yield).

Futures

In the

futures markets A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivatives contracts to buy or sell specific quantities of a commodity or f ...

, there is no assurance that a liquid market may exist for offsetting a commodity contract at all times. Some future contracts and specific delivery months tend to have increasingly more trading activity and have higher liquidity than others. The most useful indicators of liquidity for these contracts are the trading volume and

open interest Open or OPEN may refer to: Music * Open (band), Australian pop/rock band * The Open (band), English indie rock band * ''Open'' (Blues Image album), 1969 * ''Open'' (Gerd Dudek, Buschi Niebergall, and Edward Vesala album), 1979 * ''Open'' (Go ...

. There is also

dark liquidity In finance, a dark pool (also black pool) is a private forum (alternative trading system or ATS) for trading securities, derivatives, and other financial instruments.price discovery In economics and finance, the price discovery process (also called price discovery mechanism) is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers. Overview Price discovery is diff ...

Banking

In banking, liquidity is the ability to meet obligations when they come due without incurring unacceptable losses. Managing liquidity is a daily process requiring

bankers A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital m ...

to monitor and project cash flows to ensure adequate liquidity is maintained. Maintaining a balance between short-term assets and short-term liabilities is critical. For an individual bank, clients' deposits are its primary liabilities (in the sense that the bank is meant to give back all client deposits on demand), whereas reserves and loans are its primary

s (in the sense that these loans are owed to the bank, not by the bank). The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity. Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. Banks have several additional options for generating liquidity, such as selling loans, borrowing from other banks, borrowing from a

, such as the

US Federal Reserve bank The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of ...

, and raising additional capital. In a worst-case scenario, depositors may demand their funds when the bank is unable to generate adequate cash without incurring substantial financial losses. In severe cases, this may result in a

bank run A bank run or run on the bank occurs when many Client (business), clients withdraw their money from a bank, because they believe Bank failure, the bank may fail in the near future. In other words, it is when, in a fractional-reserve banking sys ...

. Banks can generally maintain as much liquidity as desired because bank deposits are insured by governments in most developed countries. A lack of liquidity can be remedied by raising deposit rates and effectively marketing deposit products. However, an important measure of a bank's value and success is the cost of liquidity. A bank can attract significant liquid funds. Lower costs generate stronger profits, more stability, and more confidence among depositors, investors, and regulators.

Stock market

The market liquidity of

stock Stocks (also capital stock, or sometimes interchangeably, shares) consist of all the Share (finance), shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporatio ...

depends on whether it is listed on an

exchange Exchange or exchanged may refer to: Arts, entertainment and media Film and television * Exchange (film), or ''Deep Trap'', 2015 South Korean psychological thriller * Exchanged (film), 2019 Peruvian fantasy comedy * Exchange (TV program), 2021 Sou ...

and the level of buyer interest. The bid/ask spread is one indicator of a stock's liquidity. For liquid stocks, such as

Microsoft Microsoft Corporation is an American multinational corporation and technology company, technology conglomerate headquartered in Redmond, Washington. Founded in 1975, the company became influential in the History of personal computers#The ear ...

General Electric General Electric Company (GE) was an American Multinational corporation, multinational Conglomerate (company), conglomerate founded in 1892, incorporated in the New York (state), state of New York and headquartered in Boston. Over the year ...

, the spread is often just a few pennies – much less than 1% of the price. For illiquid stocks, the spread can be much larger, amounting to a few percent of the trading price.

References

Sources

"Liquidity: Finance in motion or evaporation"
lecture by Michael Mainelli at

Gresham College Gresham College is an institution of higher learning located at Barnard's Inn Hall off Holborn in Central London, England that does not accept students or award degrees. It was founded in 1597 under the Will (law), will of Sir Thomas Gresham, ...

, 5 September 2007 (available for download as an audio or video file, as well as a text file)
The role of time-critical liquidity in financial markets
by David Marshall and Robert Steigerwald (Federal Reserve Bank of Chicago)
Financial market utilities and the challenge of just-in-time liquidity
by Richard Heckinger, David Marshall, and Robert Steigerwald (Federal Reserve Bank of Chicago)