What is market liquidity? Definition, calculation, and examples
Rebecca Cattlin June 22, 2021 11:51 PM
Market liquidity is a key component of a functioning financial market, as it determines how fast trades can be executed at the preferred price. Discover what market liquidity is, how it is measured and what the most liquid markets are.
What is meant by market liquidity?
Market liquidity is the extent to which an asset can be bought or sold at the current market price, without impacting its value. It is simply how fast you can exchange something for cash. Liquidity applies to any financial market, from stocks to precious metals, but some are more liquid than others.
When people talk about liquidity, they’re usually either referring to market liquidity or accounting liquidity.
- Market liquidity – this is the measure of how efficiently a market (such as the stock market or forex market) enables participants to buy and sell assets at stable prices. It will be characterised by high trading volumes and a close bid-ask spread
- Accounting liquidity – this is a term used to describe whether a company can meet its financial obligations with the assets available to them. This metric is commonly used by investors and analysts to determine how strong a company’s balance sheet is
What causes market liquidity?
Market liquidity is caused by trading activity. When there are high levels of trading activity – meaning there is both supply of, and demand for, the asset in question – individuals will be able to easily complete transactions. Finding someone willing to take the other side of an exchange is easier, so there will be little effect on the market price.
In a market with low activity, a single sale can take a lot longer to complete due to a lack of willing buyers and sellers. Once a transaction has taken place, it can have a much larger impact on the market price to account for the lack of willing participants.
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How to measure liquidity in the market
Market liquidity is difficult to measure as it doesn’t have a fixed value. But there are a few indicators that can be used to assess how liquid a market is. These are:
- Trading volume – this is a measure of the total number of a given asset that was traded over a certain period. High volume typically mean more liquidity and better execution, while low volume means there will be fewer counterparties available
- Bid/ask spreads – the difference between the prices buyers and sellers are willing to accept will lessen in liquid markets and widen in illiquid markets. When the spread in the underlying market is lower, it means your provider will be able to charge you lower spreads to execute your trade
- Turnover ratios – share turnover is a means of calculating liquidity in equity markets by dividing the total number of shares traded during a period by the average number of outstanding shares for the same period. In theory, the higher the share turnover, the more liquid the market
Accounting liquidity is measured with specific ratios. The three most common are:
- Current ratio – the number of current assets divided by current liabilities
- Quick ratio – the total sum of cash, accounts receivable and equities divided by liabilities
- Cash ratio – the total amount of cash divided by liabilities
Is market liquidity good or bad?
Liquidity is a very good thing. Financial markets need enough market liquidity to ensure that traders can efficiently exchange assets and investment instruments. High levels of liquidity will make it easier to open and close positions quickly and lead to a tighter bid-ask spread. These favourable conditions then only increase the number of active market participants, which in turn adds to liquidity.
When a market isn’t liquid, it becomes difficult to buy or sell goods, so you’ll either have to wait a long time for a counterparty to come along or give up on your transaction altogether. In an illiquid market, buyers and sellers cannot agree on the price of the market, which usually leads to wider bid-ask spreads and higher execution costs.
What are the most liquid markets?
The most liquid market is cash because it can instantly be converted into other assets. Meanwhile, markets that deal in physical assets are less liquid – such as real estate and fine art – as the sale process takes much longer.
Here are some of the other most liquid markets:
- Forex – the forex market is thought of as the most liquid market in the world. Major pairs are traded by governments, banks, and even individuals when they’re going on holiday. Unlike other highly liquid markets, the forex market doesn’t have stable pricing. The forex market is famous for its volatility, which is what makes it so exciting to traders. Minor pairs and exotic pairs are less well traded, which makes them less liquid
- Stocks – the stock market as a whole varies in terms of liquidity, with large-cap stocks being generally more liquid than small caps. These more liquid shares will have more stable prices and are likely to have a higher number of active traders willing to buy and sell them
- Commodities – each commodity market will have different levels of liquidity. Oil is the most highly traded commodity, which typically means it’s a liquid market – although issues such as storage shortages have been known to lead to liquidity risk when no one is willing to buy the commodity.
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