What is Liquidity?

Market makers provide liquidity, but what is liquidity? Liquidity refers to how quickly and easily an asset can be bought or sold in large quantities for a fair price. Let’s consider some real world examples to explore three different aspects of liquidity: price, volume and time.

Selling a house

When a property is sold, it typically requires weeks (or months) of advertising, inspections, face-to-face negotiation, agent commissions and taxes to be paid. Or, if the sale must occur immediately, an auction with no reserve could result in a price that is much lower than the fair market value of the property. Compared to some other assets, a house would be considered “illiquid” (i.e. it is not liquid; it has relatively low liquidity).

Selling a common, popular car

The market for second hand cars – think Toyota Camry more so than Bugatti Veyron – is relatively more liquid than the housing market. It is easy to search for many other practically identical cars on a car trading website to find a fair price, and if you need to sell it immediately you can go to a car dealer to do so. The trade price you get from the dealer might not be a good price, but it will be predictable and reliable – unlike auctioning a house in a rush.

Buying 1,000 worth of Telstra shares

This is easy for anyone with a broker account, which most adults can open online within a few days. Telstra is a highly liquid stock; over $100m worth of shares are transacted every day, and there is only one major market. Thus anyone can observe and trade at a fair market price at all times online. A $1,000 parcel of Telstra shares is highly liquid compared to almost any other asset.

Buying 5 billion worth of Telstra shares

This is a different story. $5bn is more than 10% of the company and 50x the amount that trades on the exchange every day. To execute such a transaction at a reasonable price, you would probably need to engage an investment bank – not to mention the fact large investments in public companies can attract (potentially unwanted) attention and have legal implications in relation to takeover laws, foreign ownership etc. As such, a $5 billion parcel of Telstra shares is much less liquid than a $1,000 parcel.

Liquidity & Market Making

The market for financial products is vast, and not every asset is as popular or easy to trade as Telstra shares.

Imagine trying to find another investor who wants to do the exact opposite trade to you at exactly the same time – it would be practically impossible.

The role of the market maker is to continuously provide bid and offer prices in the market so that investors can always access liquidity on a broad range of financial products.