In business parlance, the word “liquidity” is often used as a characteristic of an asset (i.e., actually a commodity). In this case, liquidity is the ability of an asset to be quickly and safely bought or sold for money without significantly affecting its value. If a commodity (asset) can be sold quickly at a good price, it is liquid, and vice versa, an illiquid commodity is hard to sell and may have to be reduced in price.
How the stock market works. Liquidity in a glass
To illustrate the concept of liquidity in more detail, let’s turn to the stock market. To begin with, let’s remember how the price of an asset is formed on the stock exchange. Buyers and sellers place bids (orders) to buy and sell assets. These orders are displayed in the so-called order book, which is known among Russian-speaking traders as “stock exchange quotation glass” (or simply “glass”).
To place an order, a buyer must have a corresponding amount of money in his account. When an order is placed, this money is blocked until the order is executed (then the money is transferred from the buyer to the seller) or canceled (then the money is returned to the buyer’s account). Accordingly, a seller who wants to place a sell order must have a corresponding exchange asset (e.g. bitcoin, gold, grain futures, etc.) that will be blocked in the order. When the buy and sell price match – the transaction occurs.
Liquidity is exactly what is blocked in exchange orders, i.e. money that buyers are willing to spend to buy an exchange-traded asset. Thus, liquidity is the presence in the market of buyers who have money and are ready to buy the asset.
Liquidity as money
Ultimately, liquidity can be understood as money itself. When people talk about “liquidity inflow” they mean that money has started to flow into the market, but we should not forget that money goes where it is directed by its owners, who must be ready to spend it. That is, willingness is also important.
On the other hand, if an asset lacks liquidity, it means that demand for it is low and there is little money in the market, but why? Potential buyers may want to buy, but they simply may not have the money, so money is the primary component of liquidity.
If there is money, there will be a willingness to buy, and when there is a willingness to buy, then the product will have the ability to be sold, so liquidity is first of all money, and then the willingness of the buyer to buy and the ability of the product to be sold.
The concept of spread is closely related to exchange liquidity. The spread is the difference between the price at which an asset can be bought and the price at which it can be sold. In the context of financial markets, the spread usually refers to the difference between the bid and ask price for traded assets such as cryptocurrencies, fiat currencies, stocks, bonds or commodities.
The bid price is the maximum price at which a buyer is willing to buy an asset and the ask price is the minimum price at which a seller is willing to sell an asset. The difference between these two prices is the spread.
Liquidity and the spread are closely related, as the spread is one measure of market liquidity. A narrower spread usually indicates a more liquid market because it means that there are many buyers and sellers willing to transact at close prices. A wider spread may indicate a less liquid market where bid and ask prices differ significantly.
When the market is more liquid, spreads tend to be narrower because the large number of buyers and sellers allows trades to be made at closer prices. In a low liquidity situation, spreads may be wider because a limited number of market participants are willing to trade at current prices, which limits competition and widens the area between the bid and ask prices.
Thus, liquidity and spreads are related in the sense that increased liquidity usually leads to narrower spreads, while low liquidity may lead to wider spreads.
Investors and traders usually seek to minimize the spread in order to reduce their trading costs and get the best price when buying or selling an asset. This can be achieved by choosing brokers with low commissions and narrow spreads, and by actively trading in liquid markets.
Key liquidity indicators:
- trading volume. The higher the trading volume on the market, the higher its liquidity.
- Market depth, i.e. the number of offers to buy and sell an asset at different prices. The deeper the market is, the easier and faster the transactions are carried out.
- efficiency of execution of deals, estimated by the time and cost of execution of deals.
Factors affecting exchange liquidity
Various factors can affect the level of market liquidity. One such factor is the size and structure of the market. Some markets may be more liquid because of the larger number of sites and better trading structure. The number of participants and their activity also affect the liquidity of the market. The more participants and the more active they trade, the higher the level of liquidity. In addition, market accessibility and the quality of technical infrastructure also play an important role in determining the level of liquidity.