Market liquidity

A house is worth what someone will pay for it. But if you must sell by Friday, it is worth what the one buyer around on Friday will pay. Every asset has that Friday price. Liquidity is the gap between the two.

An asset is liquid if you can sell a meaningful amount of it quickly, cheaply and close to the current price. That is market liquidityHow quickly and cheaply you can buy or sell a meaningful amount without moving the price much.. A bank deposit is perfectly liquid. Shares in a large company are very liquid on a normal day. A building, a private company or a work of art can take months to sell, and the price you get depends on who happens to be looking.

The order book from L1.1.06 lets us see liquidity directly. It has three dimensions:

A small order only pays half the spread. A large one walks down the book, level by level, and pays more for every level it uses. The extra is its price impactHow far a trade moves the price against the trader as it uses up the book.. In a deep market the levels are thick and close together, so impact is small. In a thin market the levels are thin and far apart.

Here is the same share on two days. On the calm day, 38,000 shares are bid within 0.5% of the mid and the spread is 0.10%. On the stress day, only 300 are, and the spread is 1.00%:

Why liquidity vanishes in stress

Liquidity is not a fixed property of an asset. It depends on people being willing to trade, and in a crisis they stop. Market makers face bigger price swings, so they quote wider and smaller, or not at all. Meanwhile many holders need to sell the same things at the same time. The result can feed on itself. Step through the loop.

Step 2 shows a second kind of liquidity. Funding liquidityA firm's ability to pay what it owes when due, by holding cash or being able to borrow it. is a firm's ability to pay what it owes on time. A firm that runs short of funding liquidity must sell assets, and then depends on their market liquidity. The two kinds of shortage drive each other, which is why crises spread so fast.

We measure the cost of a trade against the mid price $m$ before the trade. In L1.1.06 a market order of $q$ shares paid an average price $\bar p$. For a sale, start from the plain statement and fill it in one line at a time:

As a percentage, divide by the value at the mid: $(m - \bar p) / m \times 100$. For a purchase, swap the sign: $q \times (\bar p - m)$. The cost has two parts: half the spread, paid on even the smallest trade, and price impact on top.

Sell the same number of shares into each book. Start at 5,000, then push the slider to the end. On the stress day, look at how many price levels you need, and what happens near 10,000.

A fund must sell 5,000 shares at market. Both days start with a mid of €40.00. Try each step before revealing it.

Under Basel III, banks must meet a Liquidity Coverage Ratio (LCR): enough high-quality liquid assets to survive 30 days of stress, with less liquid assets counted at a discount. The LCR, and how funds manage redemptions when their assets are hard to sell, return in later levels on liquidity risk.

• Market liquidity is the ability to trade a meaningful amount quickly, cheaply and close to the current price.
• Look at tightness (spread), depth (orders near the price) and resilience (how fast the book refills).
• The cost of a sale against the mid is shares × (mid − average price): half the spread plus price impact.
• Liquidity vanishes in stress: dealers step back and forced sellers all move the same way, which can become a spiral.
• Funding liquidity is the ability to pay what you owe; running short of it forces sales that test market liquidity.

Market liquidity

How quickly and cheaply you can buy or sell a meaningful amount without moving the price much.

Tightness

How small the bid-ask spread is: the cost of a small round trip.

Depth

How many shares are waiting to trade near the current price.

Resilience

How quickly new orders arrive to refill the book after a large trade.

Price impact

How far a trade moves the price against the trader as it uses up the book.

Funding liquidity

A firm's ability to pay what it owes when due, by holding cash or being able to borrow it.

Margin

Collateral a trader must post against a position; if prices move against it, it must post more (a margin call).

Fire sale

Selling assets quickly at depressed prices because you must, not because you want to.

Liquidity spiral

A loop in which falling prices force selling, which drains liquidity and pushes prices down further.