In finance and economics, “liquid” means “convertible into money”, and this is the basis for defining “liquidity”.
What Is Liquidity?
It is the feature of assets to be quickly sold at a price that is close to the market price. Assets can be divided into highly liquid, lowly liquid, and illiquid. The faster and easier you can exchange an asset, considering its full value, the more liquid it is. For a product, liquidity will correspond to the speed of its sale at a nominal price, without additional discounts. For example, the assets of an enterprise that are reflected in the balance sheet are sorted according to liquidity:
cash in the accounts and cash desks of the company;
bank notes, government securities;
current receivables, loans issued, corporate securities (shares of listed companies, promissory notes);
inventory of products and raw materials in warehouses;
cars and equipment;
buildings and constructions;
construction in progress.
The term is also used in relation to banks, money, enterprises, market, securities, etc.
The market is considered highly liquid if it has regular purchase and sale transactions in sufficient quantities of goods. Additionally, a highly liquid market is characterized by the difference in prices of bids for the purchase (bid price) and sale (ask price). Each individual transaction in such a market is typically not able to significantly impact the price of goods.
The market liquidity is indicated by a churn. It is the ratio between the volume of concluded contracts (open positions) and the value of physical volumes of goods delivered from a specific trading platform. In other words, it is the ratio of the total goods sold to the volume of their physical supply. In general, liquid markets start at an average churn of 15 and above.
Stock Market Liquidity
The stock market liquidity is typically estimated by the number of transactions (trading volume) and the value of the spread - the difference between the maximum bid price and the minimum ask price. The more deals and the smaller the difference, the greater the liquidity.
There are two basic principles for transactions:
Quotation orders – a trader issues their own purchase or sales orders and indicates the desired price. Quotation orders form instant market liquidity - the trader indicates the volume, the desired price and waits for the application to be satisfied, allowing other bidders to buy or sell a certain amount of an asset at any time at a price agreed by the trader. The more quotes placed on the asset being traded, the higher its instant liquidity.
Market - placing orders for instant execution at the current ask or bid prices. Market orders form the trading liquidity of the market - the trader indicates the volume and the price is formed automatically based on the best prices from the current quotation requests, which allows traders to buy or sell a certain amount of assets. The more market orders per asset, the higher it's trading liquidity.
In relation to money, liquidity is the possibility of use as a means of payment and the ability to maintain its nominal value unchanged. Money typically has the greatest liquidity within a particular economic system. But money cannot always be quickly exchanged for goods. For example, the reserve requirements of central banks do not allow the circulation of all banking assets. An increase or decrease in reserve requirements either locks or releases a necessary amount of money.
When a bank issues a loan, the amount of money stored in the bank decreases. The more funds issued, the greater the risk that there may be not enough money to return the deposit. In this case, bank liquidity should be reduced. The bank may also apply to the Central Bank with a request for a temporary loan, which will be considered as “additional liquidity”. Excess liquidity in banks stimulates them to place funds, including securities. A decrease in bank liquidity may result in the sale of those securities.