Have you ever heard of liquidity in finances? It is a vital element of each market that describes how quickly an asset may be sold without affecting its value. The more liquid an asset, the simpler it is to sell for a reasonable or current asking price.
In this article, we will discuss what liquidity in finances means and why liquidity is so important, and also we will talk about the main types of liquidity. Besides that, we will take a look at the main factors that can affect liquidity in the financial markets.
First things first, let's take a look at what liquidity in finances represents.
What Is Liquidity? How Does It Impact Financial Markets?
The ease with which an asset may be exchanged for another asset (usually for cash) is known as liquidity. Cash is the most liquid asset since it can be sold for products and services immediately without depreciating. On the other hand, there are assets, like property or cars, that take longer to exchange for money, so they can be considered illiquid.
Essentially, liquidity is defined as a measurement of how quickly transactions in a particular instrument or asset class may be completed. For example, sovereign bonds or shares of any major publicly traded company are simple to value and may be sold or bought fast without affecting the price.
Thus, when we talk about specific markets, say commodities or stocks, liquidity also refers to the degree to which buy-sell transactions affect pricing.
When the price shifts significantly during a purchase or sale of a particular instrument or when you are unable to trade it at all, you can call it illiquid.
A market such as Forex is considered to have high liquidity because there are a large number of buyers and sellers participating in trading, with huge volumes of currencies being exchanged every day. This creates a continuous exchange of assets as there is always someone wanting to buy or sell.
In a liquid market, a seller can quickly find a buyer without lowering the asset's price to make it more enticing. The same is true for buyers: they do not have to spend more time or funds to find their desired asset at the desired price.
In contrast, the market is illiquid if there are relatively few buyers and sellers. In such cases, trading becomes inconsistent and inconvenient.
Liquidity also affects spreads, which is the difference between a bid and ask prices — the less liquidity, the wider the spread. Narrower spreads are always more beneficial for trading, as they allow you to spend less and profit more.
Consider a market with a large number of buy and sell orders. In that case, there is a larger chance that the top bid price any buyer is interested in paying and the lowest price any seller is willing to take will move closer together — the spread will narrow in that scenario.
Forex is the most liquid market in the world due to its large volume of transactions and many participants trading 24/7. High liquidity allows main currencies, such as the US dollar, the British pound, the euro, and other major fiat currencies, to have relatively small bid-offer spreads, making them appealing investment options for various retail and institutional participants.
Why Is Liquidity Important?
Liquidity in finances is crucial, as you may have already guessed. Markets that are not liquid make selling assets or converting securities into cash more difficult.
Let's look at this example: you hold an extremely rare piece of art valued at, say, 500,000 US dollars. Such products, however, are rarely in high demand. Your asset could be insignificant for most people, and no one will pay anything near its predetermined value, thus making this piece of art extremely illiquid. In this case, you may need to ask an auction house to operate as a broker and find possible buyers, which will require additional time and capital, or you will need to decrease the price of your asset significantly so that it becomes more attractive to buyers.
Corporations must also have adequate liquid assets to satisfy their short-term commitments, such as bills or payroll; otherwise, they could risk a liquidity crisis, which might lead to bankruptcy.
Acknowledging your portfolio's liquidity is a critical aspect of risk management. If you can swiftly turn your assets into cash, you will be able to cover unforeseen costs even if the financial markets are in crisis, which happens regularly.
Now, let's take a closer look at the main types of liquidity.
Types Of Liquidity
1) Market liquidity:
Market liquidity describes the ease with which assets may be purchased and sold on an exchange, such as a particular stock exchange, real estate market, crypto market, etc.
The overall financial sector has great market liquidity. In contrast, real-product markets like car or housing markets are often significantly less liquid than financial markets. The liquidity of markets for assets, like derivatives, contracts, currencies, or commodities, is frequently determined by their size and the number of open exchanges on which they may be exchanged.
If an exchange has a significant volume of transactions, the price a buyer offers per share (the bid price) and the price a seller is ready to take (the asking price) will be relatively close (narrow spread).
2) Asset liquidity:
When an asset is purchased or sold, its liquidity relates to how effectively it may be changed to cash. As you already know, cash is the most liquid asset since it can be traded fast and readily without affecting its market value. Stocks and bonds are also regarded as highly liquid assets, albeit their liquidity varies according to the stock's popularity and dependability. Real estate and fine art are examples of illiquid assets because, while they are highly valued, they can be challenging to sell, and their prices often vary significantly with the trading environment.
Remember that the liquidity of one instrument can also differ depending on the current market circumstances and economic situation in a specific region or globally.
3) Accounting liquidity:
Another type of liquidity is known as accounting liquidity. It assesses how easily an individual or corporation can fulfill their financial commitments with the liquid assets at their disposal — the capacity to pay off debts when they come due.
Accounting liquidity is measured by comparing liquid assets to existing liabilities or financial commitments that are due within a specific period of time.
Several accounting liquidity measures vary in how they describe "liquid assets." Analysts and investors use them to determine organizations with high liquidity.
Now, let's proceed further and take a look at what are the main factors that can affect liquidity in the Forex market.
Factors That Can Affect Liquidity
1) The trading volume:
The overall quantity of digital assets traded during a specific time period is known as the trading volume. Investors frequently analyze trade volume to gauge market trends and price movements. This indicator basically illustrates how active the market is at the moment. An extremely active market is reasonably persistent and draws investors' awareness. As a result, the greater the trading volume, the greater the market liquidity.
2) Activity on trading platforms:
A growing number of reliable platforms and brokerages increases traders' opportunities, leading to a greater volume of trading and a higher level of liquidity. Furthermore, the high exchange rates on the platform can reflect a lot of movement of the asset, leading to more liquidity.
3) Restrictions and laws:
The rules and regulations within a specific territory significantly impact the liquidity rate. This, however, is not the case for every financial asset since most countries have already established procedures, and assets have been traded for years now. On the other hand, governments may prohibit using cryptocurrencies, NFTs, and other "uncontrolled" digital assets, which are growing in popularity. Where crypto assets are forbidden, users will pursue them discreetly, which makes the transaction volume lower. Lower transaction volume might result in a less liquid market. On the contrary, a jurisdiction that has legalized cryptocurrencies will see more trading activity.
4) Involvement of new market players:
Wide acceptance of new assets might bring an additional impact on the liquidity rate. The more major players offer liquid assets, the more people it will attract. Consequently, a large number of customers will boost the market by increasing its trading volume. The increased trade volume will result in increased liquidity. This all might happen, for example, with cryptocurrencies. Since several major corporations have agreed to accept cryptos, it has already led to bigger adoption, which has led to higher liquidity.
5) External factors:
There are also other elements that have an influence on various financial markets. Market dynamics, GDPs, unemployment rates, international trade, trading environment, current global trends, and so on are examples of such elements.
As an example, let's take a look at the most liquid market in the world — Forex. There are several occasions and aspects to be aware of while trading foreign exchange.
When trading or investing in foreign currencies, you should pay close attention to world economics and geopolitical situations, as these are the main drives of liquidity on the market. You may miss big moves if you are late and do not execute before a particular report is published. As a result, keeping an eye on web resources for FX-related news is strongly suggested. All of this information might assist you in keeping track of the global economy.
However, keep in mind that constantly being aware of all the factors impacting the foreign exchange trading market will not be easy and requires lots of energy and patience. Also, note that their relevance changes with time and circumstance.
When we compare Forex to other financial markets, the ability to execute transactions practically anywhere in the world has a big impact on Forex liquidity. Because Forex is the largest, most decentralized, and worldwide market, it contains traders and institutions from all over the world. These factors make it the most liquid market ever.
Central banks, large institutions, hedge funds, and other major firms have a huge effect not only on the currency market because of their involvement in altering the country's interest rate but on other assets too. To maintain economic growth in accordance with inflation, a central bank must establish a favorable interest rate balance. The Forex market, in which the value of a currency or group of currencies swings in real-time, is propelled by speculation as a result of bank decisions to raise, cut, or maintain interest rates. Aside from state officials and their actions, other elements such as natural catastrophes, terrorist attacks, wars, and conflicts can significantly impact all markets. The main point to highlight here is that if the major countries are in conflict, the whole world will feel it, as we can see in 2022.
It is true that trading liquid assets could bring you solid profits, but you must first thoroughly comprehend the market you want to be involved in. You should also pay close attention to the regular economic updates to remain informed about the factors influencing each market volatility and liquidity and conduct winning purchases as an outcome.
It's important to keep your overall investment portfolio liquid, even if you want to make good profits from rapid price changes on volatile and illiquid assets. A portfolio that ignores asset liquidity may suffer.
It is wrong to believe that only professional traders with large amounts of cash should think about liquidity. Liquidity in finances is essential for professionals indeed, but novices should also be wary of it.
Trading with the most liquid asset classes, such as stocks or Forex, is safer than trading with unusual assets. Thus, when you are just getting started trading on the financial markets, investing in assets with high liquidity means helping build your portfolio more effectively and accurately.