Trading liquidity definitions

It can be sold rapidly, with minimal loss of value, anytime within market hours. The essential characteristic of a liquid market is that there are always ready and willing buyers and sellers. It is similar to, but distinct from, market depth , which relates to the trade-off between quantity being sold and the price it can be sold for, rather than the liquidity trade-off between speed of sale and the price it can be sold for.

A market may be considered both deep and liquid if there are ready and willing buyers and sellers in large quantities. An illiquid asset is an asset which is not readily salable without a drastic price reduction, and sometimes not at any price due to uncertainty about its value or the lack of a market in which it is regularly traded.

Before the crisis, they had moderate liquidity because it was believed that their value was generally known. Speculators and market makers are key contributors to the liquidity of a market or asset.

Speculators are individuals or institutions that seek to profit from anticipated increases or decreases in a particular market price. Market makers seek to profit by charging for the immediacy of execution: By doing this, they provide the capital needed to facilitate the liquidity.

The risk of illiquidity does not apply only to individual investments: Financial institutions and asset managers that oversee portfolios are subject to what is called "structural" and "contingent" liquidity risk. Structural liquidity risk, sometimes called funding liquidity risk, is the risk associated with funding asset portfolios in the normal course of business.

Contingent liquidity risk is the risk associated with finding additional funds or replacing maturing liabilities under potential, future stressed market conditions. When a central bank tries to influence the liquidity supply of money, this process is known as open market operations. The market liquidity of assets affects their prices and expected returns. Theory and empirical evidence suggests that investors require higher return on assets with lower market liquidity to compensate them for the higher cost of trading these assets.

In addition, risk-averse investors require higher expected return if the asset's market-liquidity risk is greater. Here too, the higher the liquidity risk, the higher the expected return on the asset or the lower is its price.

One example of this is a comparison of assets with and without a liquid secondary market. The liquidity discount is the reduced promised yield or expected a return for such assets, like the difference between newly issued U. Treasury bonds compared to off the run treasuries with the same term to maturity. Initial buyers know that other investors are less willing to buy off-the-run treasuries, so the newly issued bonds have a higher price and hence lower yield.

In the futures markets , there is no assurance that a liquid market may exist for offsetting a commodity contract at all times. Some future contracts and specific delivery months tend to have increasingly more trading activity and have higher liquidity than others.

The most useful indicators of liquidity for these contracts are the trading volume and open interest. There is also dark liquidity , referring to transactions that occur off-exchange and are therefore not visible to investors until after the transaction is complete. It does not contribute to public price discovery.

In banking, liquidity is the ability to meet obligations when they come due without incurring unacceptable losses. Managing liquidity is a daily process requiring bankers to monitor and project cash flows to ensure adequate liquidity is maintained.

Initial buyers know that other investors are less willing to buy off-the-run treasuries, so the newly issued bonds have a higher price and hence lower yield. In the futures markets , there is no assurance that a liquid market may exist for offsetting a commodity contract at all times.

Some future contracts and specific delivery months tend to have increasingly more trading activity and have higher liquidity than others. The most useful indicators of liquidity for these contracts are the trading volume and open interest. There is also dark liquidity , referring to transactions that occur off-exchange and are therefore not visible to investors until after the transaction is complete. It does not contribute to public price discovery.

Maintaining a balance between short-term assets and short-term liabilities is critical. For an individual bank, clients' deposits are its primary liabilities in the sense that the bank is meant to give back all client deposits on demand , whereas reserves and loans are its primary assets in the sense that these loans are owed to the bank, not by the bank. The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity.

Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. Banks have several additional options for generating liquidity, such as selling loans, borrowing from other banks , borrowing from a central bank , such as the US Federal Reserve bank , and raising additional capital. In a worst-case scenario, depositors may demand their funds when the bank is unable to generate adequate cash without incurring substantial financial losses.

In severe cases, this may result in a bank run. Most banks are subject to legally mandated requirements intended to help avoid a liquidity crisis. Banks can generally maintain as much liquidity as desired because bank deposits are insured by governments in most developed countries. A lack of liquidity can be remedied by raising deposit rates and effectively marketing deposit products. However, an important measure of a bank's value and success is the cost of liquidity.

A bank can attract significant liquid funds. Lower costs generate stronger profits, more stability, and more confidence among depositors, investors, and regulators. In the market, liquidity has a slightly different meaning, although still tied to how easily assets, in this case shares of stock, can be converted to cash. Generally, this translates to where the shares are traded and the level of interest that investors have in the company. For illiquid stocks, the spread can be much larger, amounting to a few percent of the trading price.

Liquidity positively impacts the stock market. When stock prices rise, it is said to be due to a confluence of extraordinarily high levels of liquidity on household and business balance sheets, combined with a simultaneous normalization of liquidity preferences. On the margin, this drives a demand for equity investments. I will turn, first, to two key drivers of liquidity: A third important source of liquidity--resulting from the excess savings of emerging-market economies and those with large commodity reserves--has also found its way to the United States in pursuit of high risk-adjusted returns.

We must judge the extent to which each of these three liquidity drivers are structural or cyclical, more persistent or more temporary. Understanding the sources of liquidity--and the causes thereof--should help inform judgments about the level and direction of market liquidity.

In so doing, we may better understand its implications for the economy and policymakers alike. First, liquidity is significantly higher than it would otherwise be due to the proliferation of financial products and innovation by financial providers. This extraordinary growth itself is made possible by remarkable improvements in risk-management techniques. Hewing to my proposed definition, we could equally state that financial innovation has been made possible by high levels of confidence in the strength and integrity of our financial infrastructure, markets, and laws.

Moreover, remarkable competition among commercial banks, securities firms, and other credit intermediaries have helped expand access to--and lower the all-in-cost of--credit. Interest rate risk and credit risk exposures are now more diversified. Look no further than dramatic growth of the derivatives markets. In just the past four years, notional amounts outstanding of interest rate swaps and options tripled, and outstanding credit default swaps surged more than ten-fold.

These products allow investors to hedge and unwind positions easily without having to transact in cash markets, expanding the participant pool.

Syndication and securitization also lead to greater risk distribution. CLOs allow loans to be financed primarily with high-rated debt securities issued to institutions like mutual funds, pension funds, and insurance companies. For CLO structures to be effective, they invariably must include a more risky equity tranche. Even the most sophisticated financial products are not immune to the physical Law of Conservation of Matter--the risk must rest somewhere. Hedge funds reportedly have served as willing buyers of these riskier positions, and we are all aware of their phenomenal growth.

As important as the participation of hedge funds, the derivative products themselves allow credit risk to be hedged, which has the beneficial effect of further increasing the pool of other investors as well. The increase in financial product and provider innovation appears to be quite persistent; future trends, however, are likely to be significantly influenced by legal, regulatory, and other public policies.

The second factor, perhaps equally persistent, supporting strong investor confidence in U. In theory, reduced volatility, if perceived to be persistent, can support higher asset valuations--and lower risk premiums--as investors require less compensation for risks about expected growth and inflation.

In this manner, confidence appears to beget confidence, with recent history giving some measure of plausibility to the notion that very bad macroeconomic outcomes can be avoided. The Great Moderation, however, is neither a law of physics nor a guarantee of future outcomes. It is only a description--an ex post explanation of a period of relative prosperity.

If policymakers and market participants presume it to be an entitlement, it will almost surely lose favor. Let us look closer at the correlation between confidence and outcomes. Asset prices do appear somewhat correlated with volatility associated with the real economy and inflation. For example, equity valuations for U. In addition, term premiums on long-term U. Treasury securities are estimated to have declined substantially since the late s.

These flows to the United States from global investors lead to higher liquidity by increasing capital available for investment and facilitating greater transfer and insurability of risk. Also, some of the fastest growing economies, especially in Asia, pursued export-driven growth strategies, thereby accumulating large reserves of foreign-denominated assets. In a world of funds increasingly without borders, we would expect investors to seek out the best risk-adjusted returns.

Sound, transparent regulatory and legal frameworks in the United States, United Kingdom, and some other advanced economies have helped contribute to the attractiveness of these markets. In addition, top-notch infrastructure allows for efficient clearance and settlement procedures for transactions in the most sophisticated financial markets, all of which promote investor confidence and continued sources of liquidity.

Implications for the Economy and Challenges for Policymakers Generally, high levels of liquidity offer substantial benefits to our financial system and overall economy through higher financial asset prices and a more efficient means to channel funds between savers and borrowers.

Strong liquidity may also help to prevent imbalances in certain markets from spreading because of the greater dispersion of risks. Financial markets have been buffeted by a number of significant events, including a spate of corporate accounting scandals, the bond rating downgrades of Ford Motor Co. But the effects on broader markets appear to have been remarkably contained.

It is harder still to know precisely why. I have argued that solid fundamentals--effective and dynamic products and markets to disperse risk, stable economic performance, and robust and attractive market infrastructures--are key underpinnings for strong liquidity and correspondingly strong investor confidence.

Surely, policymakers must be vigilant to maintain output stability and low and anchored inflation expectations. In addition, policymakers need to encourage sound risk management by private participants as the first line of defense against financial instability. Of course, investor confidence and liquidity can shift. In the aftermath of a financial shock, if buyers and sellers of credit can no longer agree on the distribution of possible outcomes, their ability to price transactions will be severely limited.

While we cannot--and often should not--prevent all shocks or predict how they will reverberate through the financial system, we can attempt to create conditions that would lead investors to most quickly rebuild their confidence. That is most likely to occur when underlying fundamentals are solid. Monetary policy is no less challenged by the level and prospects for liquidity.

We policymakers must ask whether liquidity conditions are obscuring signals from financial asset prices that we would otherwise use to gauge the performance of the real economy. Of course, inferences from market prices are always imprecise, because prices depend on expected growth, the variation surrounding that expected path, and investor risk aversion, none of which we can precisely observe.

Market liquidity may further confound the inference challenges. Allow me to comment, nonetheless, on a few key indicators. Look at the current configuration of Treasury yields across the maturity spectrum. Typically, investors require compensation for the greater exposure to interest rate risk from holding longer-term securities, leading to an upward-sloping yield curve.

Since about mid, the yield curve has been about flat to downward-sloping.