Liquidity

Explained:

liquidity

liquidity black hole

The term liquidity is used in various ways, all relating to availability of, access to, or convertibility into cash.

An institution is said to have liquidity if it can easily meet its needs for cash either because it has cash on hand or can otherwise raise or borrow cash.

A market is said to be liquid if the instruments it trades can easily be bought or sold in quantity with little impact on market prices.

An asset is said to be liquid if the market for that asset is liquid.

The common theme in all three contexts is cash. A corporation is liquid if it has ready access to cash. A market is liquid if participants can easily convert positions into cash. An asset is liquid if it can easily be converted to cash.

The liquidity of an institution depends on:

the institution's short-term need for cash;

cash on hand;

available lines of credit;

the liquidity of the institution's assets;

the institution's reputation in the marketplace—how willing will counterparties be to transact trades with or lend to the institution?

The liquidity of a market is often measured as the size of its bid-ask spread, but this is an imperfect metric at best. More generally, Kyle (1985) identifies three components of market liquidity:

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tightness is the bid-ask spread;

depth is the volume of transactions necessary to move prices;

resiliency is the speed with which prices return to equilibrium following a large trade.

Persaud (2001) identifies a fourth component, which he calls diversity. This is simply the degree of diversity among market participants in their market views and desired trades. Persaud argues that lack of diversity can lead to liquidity black holes. These are conditions where liquidity dries up, and a decline (or increase) in prices brings out more sellers (or buyers), further exasperating the price move. This is the exact opposite of what would be expected in a regularly functioning market, where, a price decline would bring out bargain hunters. Perhaps the classic example of a liquidity black hole is the 1987 stock market crash.

Examples of assets that tend to be liquid include foreign exchange, stocks traded on the New York Stock Exchange or on-the-run Treasury bonds. Assets that are often illiquid include limited partnerships, thinly traded bonds or real estate.