Understanding Liquidity and Market Liquidity

An asset’s liquidity refers to the ease with which an asset can be bought or sold. Within the financial markets, the term often relates to the rapid conversion of a financial security to usable cash, since cash is considered the most liquid asset. By extension, market liquidity measures the speed that trade can execute without causing any change to the underlying market price. As a result, market liquidity is highly important to Forex markets, where buying and selling a currency pair won’t create significant price movement of the currency itself.

Market Liquidity Explained

Tangible stores of value such as property, collectibles, goods and vehicles are all difficult to buy or sell relative to cash. Each financial vehicle falls on a different location of the liquidity spectrum, with illiquid assets representing the hardest to trade.

On the other hand, liquid assets with rapid trade times (like securities) can trade hands multiple times a day with transaction volumes well into the millions. Such trading speed is of particular importance for brokers and market makers, as without a seamless volume of trades, market function decreases. Liquidity allows for prices to better reflect the ebbs and flows of supply and demand, and market makers can charge a spread on the bid-ask price (or even provide liquidity to clients as the market demands). Liquid assets by nature can transact with ease, and that keeps prices stable for a more active and safe market.

Without liquidity, brokers can run into trouble due to the possibility of drastic price fluctuations. Since illiquid assets are hard to exchange, market activity mutes and bid-ask spreads widen. Even if the item is of immense value (e.g. rare collectibles), the lengthy sale process results in few interested buyers. The asset is hard to sell and the market participants are limited, so pressure builds on the seller to price the item at a discount. The very act of trading an illiquid asset can lower its accepted price, even beyond the expected book value. A lack of depth in the market causes losses and makes for a disordered market.

The Importance of Market Liquidity

Market liquidity is important because it decreases risk.

If there are no buyers for a particular asset, its cash value becomes irrelevant. It does not matter if it is a stock or an art piece, without a trading partner, the item can return no wealth. Immense illiquidity introduces trade risk.

Investors are wary of that liquidity risk and seek financial vehicles with plenty of active buyers and sellers. Brokers do well by finding or supplying such liquidity to their customers, contributing to the growth of the market itself. The larger the number of players in the field, the higher the likelihood you can supply investment opportunities to clients at prices they are willing to accept.

High market liquidity also lowers overall costs, for both brokers and clients. If there is an imbalance of supply and demand, the difference between what investors will bid and what a seller asks widens. The few interested participants in a particular asset cannot agree on the price, so trade execution time extends. Costs increase, hurting all market players.

Conversely, with high market liquidity, numerous buyers and sellers can execute transactions. Any seller can rapidly turn to buy a currency without it affecting price stability. High market liquidity and the presence of many buyers make price adjustments due to trading occurring in small increments.

How Liquidity Affects Asset Value

If investors feel like the costs to trade or acquire a currency are too high, they will shift to more promising ventures. For example, slow order routing, brokerage commissions and settlement costs can all prevent active capital allocation. For brokers and market makers, a lack of activity decreases trade volume, lower commission values or adds on liquidity premiums. Growth for markets and organizations slows, hurting profits.

With that knowledge, governments, businesses and market makers all attempt to create an efficient market structure. Investors will always weigh the costs of not filing a trade with the ease of a transaction, a smooth equity market flow created by liquidity protects asset values and investor security.

STP Vs Market Maker

Forex transactions are highly liquid and occur Over-the-Counter (OTC) with traders across the world. As a result, the main market participants are liquidity providers and major banks. FX Brokers have a choice of executing investor trades with the market participants (known as the interbank market) through two models, Straight Through Processing (STP) or Market Maker.

STP works through a connected electronic system where the broker has no direct impact on the execution of an order. All bids or asks deliver to a central, liquid pool that competes to complete trades. As a result, trades execute quickly, and brokers take on limited risk. Money is earned on trading turnover, and brokers can select from a variety of liquidity pools that offer the best (and most accurate) currency prices.

Market makers bring the actual market liquidity to their clients. The market maker will buy and sell currency on the open market and deliver that to investors. This often requires the broker to take the opposite side of the trade, meaning they make earnings off of client losses. In a highly liquid market, when the client buys, the market maker sells, though the market maker decides at what prices orders are filled. As a result, currency price movements are often more stable with Market Maker brokers.

Both methods make a market and supply liquidity to investors who want to make purchases. The ideal method will depend on preference and risk tolerance, MM can make more money, but STP is more trusted and executed faster.

Measuring Market Liquidity

Market liquidity is not a fixed value, so brokers can measure overall market activity by referring to three key indicators:

Trading Volume – Trading volume refers to the amount of a particular security that transacts over a set period of time. A high volume of trades indicates the presence of numerous buyers and sellers who could make trades with ease.

Bid/Ask Spreads – The Bid/Ask spread measures the difference in price agreement between a buyer and a seller for a particular asset. The similarity, in the bid and ask prices infers faster transaction speeds with better price stability.

Turnover Ratios – Turnover ratios refer to how often an asset trades against the total number of available shares. If a particular company has little stock turnover combined with a large amount of leftover stock, investors assume it is unpopular. Supply is too high, so it will be hard to sell the stock at a later date, even if the stock increases in value.

The Most Liquid Markets

Where can brokers find market liquidity? Cash and cash equivalents remain the most liquid asset class because they can buy almost any goods and services. All other asset classes are defined relative to their conversion to cash, with marketable securities as the most liquid.

● Forex: Governments, banks and major investment groups all engage at scale on the Forex markets. Foreign reserves back liabilities and foreign policy, resulting in a daily volume of around $6.6 Trillion.
● Stocks: Different markets, exchanges and indexes all support a variety of options on the liquidity spectrum. On average, the support structures in equities offer rapid execution and high trade volume, especially for large-cap stocks.
● Commodities: While commodities are quite illiquid due to their relation to a physical resource, financial instruments (e.g. derivatives) can create market liquidity. Commodities with routine application in daily life (oil, gold and other precious metals) maintain high levels of liquidity.

Conclusion

For brokers, especially in Forex markets, liquidity is a necessity, as even though the asset can transact quickly, limited financial institutions and liquidity pools can limit your ease of entering or exiting a trade (currency pair). Active currency pairs such as GBP/USD or USD/JPY have extended liquidity, allowing for easy buying and selling without any drastic effect on price. Brokers would do well to watch for price gaps or widening bid/ask spreads as signs of muted market activity and the threat of illiquidity.

source https://www.financemagnates.com/forex/education-centre/understanding-liquidity-and-market-liquidity/?tg=1657794987