What Is Liquidity

What Is Liquidity

There is a chain of bistros in British Columbia called Liquidity Wines and while they’re not involved in financial markets their business model helps us understand what liquidity really is. Liquidity describes how smoothly and efficiently an asset can be bought and sold without skewing the price. Liquidity should never be confused with hydration or an actual beverage!

In the normal course, Liquidity Wines have no difficulty sourcing wine from the vineyard and settling on a retail price that’s printed on their menus all year round. But the risks they run are that their suppliers can’t meet demand – too few vines or too many customers. The balance between supply and demand is crucial to our understanding of liquidity.

Cash (or its digital equivalent) is the ultimate expression of liquidity because it is easily accessible and readily convertible to other assets. For example, if you wanted to buy a new car – selling part of your family home to cover the cost would be a ludicrous option. In order to meet the definition of liquidity the product or asset must be freely available and capable of being speedily converted.

Liquidity Wines are not complacent – they have contracts with a selection of wineries and are not overly-dependent on any particular vineyard. This seems like an excellent contingency plan until fire or disease devastates all of the vineyards in their area. Result – there is no wine available at any price!

Company accountants have long recognised the need for emergency funds. Of course, they don’t call them that because it sounds too scary. Nonetheless, accountants hold “cash at bank” and “current assets” that provide adequate liquidity when something unexpected occurs and the assets can be easily converted to liquid cash.

Most financial markets provide liquidity – end-of-day or, indeed, up-to-the-minute valuations with a preponderance of buyers and sellers providing reassurances on pricing and price availability. Where the underlying asset is popular the concept of liquidity is nonchalantly taken for granted. Where the product is more obscure it is generally recognised that the extent of the liquidity available is diminished. Oftentimes, the belief in ever-present liquidity smacks of childish complacency. Market participants should know better.

In standard functioning markets it is usually not too difficult to match all buyers and sellers at acceptable prices. Computers can now scour all market platforms seeking out favourable deals and alerting brokers so that buyers and sellers can be paired. Such enhanced turnover adds to the notion of endless liquidity. But examples abound that computers can also misread market pricing and produce inadvertent imbalances between buyers and sellers.

Liquidity should not be taken as sacrosanct. It is only present due to the activities of buyers and sellers in normal market conditions. Take away the buyers or the sellers or normal market conditions and liquidity has a predilection to disappear very quickly. Caveat emptor (buyer beware) is a useful rule of thumb for anybody buying an asset. Similar guidance should be given to warning those who depend on liquidity.