What Is Liquidity and Why Does It Matter
5 min read · · Korean original
Contents 6
TL;DR
- Liquidity is a measure of how quickly and easily an asset can be converted into cash or another asset.
- Assets in financial markets, such as stocks and crypto assets, can be bought and sold quickly for cash without significantly affecting their overall market value.
- Assets such as real estate or artwork are relatively illiquid, so it can be hard to complete a trade at the price you want, and just a few trades can move the price significantly.
The Meaning of Liquidity
Liquidity refers to how easily an asset can be bought or sold without significantly affecting its price. The more liquid an asset is, the easier it is to buy and sell, while less liquid assets may take more time and effort to trade.
For example, a gold bar and a book kept in a museum both hold considerable value, but their liquidity is different. It is much easier to find a buyer for a gold bar than for a rare book. So a seller holding a gold bar can trade it in a far more liquid market. The market for rare books, however, is almost nonexistent, which makes the chances of selling one at the price you want very low.
In financial markets, liquidity is very important because it tells you how easily an asset can be turned into cash. If you hold highly liquid assets, you have the flexibility to trade them quickly whenever you want.
In trading, a highly liquid market lets you enter or exit a position while minimizing slippage, which is the difference between the expected price and the executed price.
For businesses, liquidity is essential for smooth operations. A company needs enough cash or easily convertible assets to pay its employees and pay other companies. A lack of liquidity can lead to financial difficulties and serious problems in running the business.
Why Liquidity Matters
Liquidity is an important concept for everyone from individuals to businesses. Here is why it matters.
- Smooth trading
Liquidity keeps financial markets running smoothly by letting assets be converted into cash quickly and without hassle. For example, when liquidity is plentiful, you can buy and sell stocks quickly through an online broker. This high accessibility lets investors execute trades promptly and creates a more efficient market. - Fair valuation
Liquidity enables a continuous flow of trades and information, which helps discover a fair price. A liquid market lets buyers and sellers trade at any time and ensures assets can be traded at reasonable prices. - Market stability
High liquidity reduces the impact that large buy or sell orders have on an asset's value. In a liquid market, even sizable trades have less effect on the price, which minimizes price manipulation and promotes a fair market. - Investment flexibility
Highly liquid assets give investors greater flexibility and accessibility. Because investors can quickly convert their holdings into cash or other assets, they can seize investment opportunities or respond flexibly to unexpected cash needs.
Highly Liquid and Illiquid Assets
1. Highly liquid assets
- Stocks of large global companies
Shares of large global companies listed on stock exchanges are actively traded, and many investors often provide liquidity for them. - Cash and cash equivalents
Cash means physical money such as banknotes and coins, as well as deposits held in bank accounts. Because cash can be used immediately in transactions or easily converted into other assets, it can be considered the most liquid form of asset. Cash equivalents are short-term, highly liquid investments that can easily be converted into cash, such as money market funds and Treasury bills. - Crypto assets with a high market cap
Crypto assets with a high market cap, such as Bitcoin or Ethereum, offer substantial trading volume and liquidity. As a result, market participants can easily buy and sell them without significantly affecting their price.
2. Illiquid assets
- Real estate and cars
Buying and selling real estate or cars takes extra time and effort, so they are relatively illiquid. - Art and collectibles
Art and collectibles can be highly valuable, but trading them may take a long time because they require specialized buyers and intermediaries. - Unlisted shares
Investments in private companies usually take place in minor markets, so their liquidity is limited compared with trading on an official stock exchange.
Understanding Liquidity Risk
Liquidity risk is the possibility that you can't sell an asset or security quickly enough, or at a fair price, because of a lack of market demand. It is the risk of being unable to quickly convert your investments into cash at the price you want.
For financial institutions, liquidity risk arises when there is an imbalance between cash inflows and cash outflows. For businesses, liquidity risk occurs when they run short of cash or liquid assets to meet short-term financial obligations such as payroll or loan repayments.
In the crypto market, it refers to the possibility that a particular DeFi protocol or liquidity pool lacks liquidity or available funds. This can lead to difficulty executing trades, high slippage, or situations where you can't withdraw funds from the protocol.
Closing Thoughts
Liquidity plays an important role in keeping markets running smoothly and letting investors buy and sell assets efficiently. High liquidity gives investors flexibility, fair asset valuation, and market stability. On the other hand, low liquidity can make trading difficult and may prevent you from trading assets at a fair price, so caution is needed.
