In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs. However, currencies, even major currencies, can suffer loss of market liquidity in large liquidation events. For instance, scenarios considering a major dump of US dollar bonds by China, Saudi Arabia, or Japan (each of which holds trillions of dollars in such bonds) would certainly affect the market liquidity of the US dollar and US dollar denominated assets. There is no asset whatsoever that can be sold with no effect on the market.
Liquidity also refers both to a business's ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves. An act of exchange of a less liquid asset with a more liquid asset is called liquidation.
Liquidity is defined formally in many accounting regimes and has in recent years been more strictly defined. For instance, the US Federal Reserve intends to apply quantitative liquidity requirements based on Basel III liquidity rules as of fiscal 2012. Bank directors will also be required to know of, and approve, major liquidity risks personally. Other rules require diversifying counterparty risk and portfolio stress testing against extreme scenarios, which tend to identify unusual market liquidity conditions and avoid investments that are particularly vulnerable to sudden liquidity shifts.
A liquid asset has some or all of the following features: It can be sold rapidly, with minimal loss of value, any time within market hours. The essential characteristic of a liquid market is that there are always ready and willing buyers and sellers. Another elegant definition of liquidity is the probability that the next trade is executed at a price equal to the last one. A market may be considered deeply liquid if there are ready and willing buyers and sellers in large quantities. This is related to market depth that can be measured as the units that can be sold or bought for a given price impact. The opposite is that of market breadth measured as the price impact per unit of liquidity.
An illiquid asset is an asset which is not readily salable 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 are examples of illiquid assets, as their value is not readily determinable despite being secured by real property. Another example is an asset such as a large block of stock, the sale of which affects the market value.
The liquidity of a product can be measured as how often it is bought and sold; this is known as volume. Often investments in liquid markets such as the stock market or futures markets are considered to be more liquid than investments such as real estate, based on their ability to be converted quickly. Some assets with liquid secondary markets may be more advantageous to own, so buyers are willing to pay a higher price for the asset than for comparable assets 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 remaining until maturity. Buyers know that other investors are not willing to buy off-the-run so the newly issued bonds have a lower yield and higher price.
Speculators and market makers are key contributors to the liquidity of a market, or asset. Speculators and market makers are individuals or institutions that seek to profit from anticipated increases or decreases in a particular market price. By doing this, they provide the capital needed to facilitate the liquidity. The risk of illiquidity need 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. 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 tries to influence the liquidity (supply) of money, this process is known as open market operations.
The effect of market liquidity on asset values
The market liquidity of assets affects their prices and expected returns. Theory and empirical evidence suggests 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 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.
In the futures markets, 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.
There is also dark liquidity, referring to transactions that occur off-exchange and are therefore not visible to investors until after the transaction is complete. It does not contribute to public price discovery.
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 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 assets (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 central bank, such as the US Federal Reserve bank, 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. Most banks are subject to legally-mandated requirements intended to help banks avoid a liquidity crisis.
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.
One way to calculate the liquidity of the banking system of a country is to divide liquid assets to short term liabilities.
- Christoph G. Rösch: Market Liquidity: An empirical analysis of the impact of the financial crisis, ownership structures and insider trading. 1. Auflage. Shaker, ISBN 978-3844-01237-8.
- Keynes, John Maynard. A Treatise on Money 2. p. 67.
- Wyatt, Edward (December 20, 2011) "Fed Proposes New Capital Rules for Banks" The New York Times
- "Illiquid" at financial-dictionary.discretionary.com
- Yakov Amihud and Haim Mendelson, “Asset Pricing and the Bid-Ask Spread.” Journal of Financial Economics 17, 1986.
- Viral Acharya and Lasse Heje Pedersen, “Asset pricing with liquidity risk.” Journal of Financial Economics 77, 2005.
- See a review in Amihud, Mendelson and Pedersen, Market Liquidity, Cambridge University Press, 2013. http://www.cambridge.org/aus/catalogue/catalogue.asp?isbn=9780521139656