Market liquidity and the cost of trading

Market liquidity is the ability to buy or sell an asset quickly, including in large amounts, with limited transaction costs and limited adverse effect on its price. The IMF’s framework treats liquidity as more than the presence of a quoted price: execution speed, trading costs and the price effect of the order all matter.

That distinction affects investors’ trading costs and can affect the funding costs of companies, governments and other borrowers, according to Brookings. When a given trading volume causes larger price moves, liquidity is lower and volatility can be greater.

Speed, cost and trade size

A market can accommodate a small trade at its displayed price while offering little capacity for a large order. The bid-ask spread is one visible measure of the cost of immediate trading. A narrower spread is generally associated with more liquid trading, but a spread alone does not show how much can be traded before the price changes.

Consider an illustration. A security may display a bid of $99.95 and an ask of $100.05. A sale of 100 units may execute near the bid, while an attempt to sell 100,000 units could require lower prices as available buying interest is used. The resulting movement in price is the order’s price impact.

The IMF working paper identifies five related characteristics of market liquidity: tightness, immediacy, depth, breadth and resiliency. Tightness refers to transaction costs, including bid-ask spreads and implicit costs. Immediacy concerns the speed of execution and settlement. The remaining dimensions address the market’s capacity to handle trading interest and its behaviour as prices adjust.

How liquidity is measured

There is no single theoretically correct or universally accepted measure of liquidity, the IMF paper says. A practical assessment therefore uses several indicators and considers the market and trade size in question.

• Bid-ask spreads and other transaction-cost measures assess the direct and implicit cost of trading.
• Turnover ratios and volume-based measures show trading activity.
• Execution and settlement information can indicate immediacy.
• Price-impact measures assess how far trades move prices.

These measures can give different signals. Bid-ask spreads can be informative about the cost of a routine trade, while price-impact measures address the ability to transact in size. The IMF notes that, in periods of stress and sharply changing fundamentals, prompt price discovery and adjustment can become more significant than transaction costs alone.

Terms that are often confused

Market liquidity concerns the tradability of an asset in a market. Accounting liquidity is different: it concerns whether an individual or company can meet obligations with available liquid assets. The current ratio, calculated as current assets divided by current liabilities, is an accounting-liquidity measure rather than a measure of how readily a security can be traded.

Global liquidity has a separate meaning in the Bank for International Settlements’ terminology. The BIS uses it to mean the ease of financing in global financial markets, and its indicators track credit to non-bank borrowers through bank lending and international debt securities. Those indicators do not measure the tradability of an individual security.

The useful question is conditional: how readily can this asset be traded, in what size and under what conditions? Looking at cost, speed, activity and price impact provides a more complete answer than any one headline measure.

Frequently asked questions

How is market liquidity measured?

It is assessed with several indicators because no single measure captures every dimension. The IMF working paper identifies bid-ask spreads and other transaction-cost measures, turnover ratios, volume-based measures and price-impact measures; execution and settlement information can also indicate immediacy.

What is the difference between market liquidity and accounting liquidity?

Market liquidity concerns the ability to trade an asset efficiently. Accounting liquidity concerns the ability of a company or individual to meet obligations with liquid assets, commonly assessed by comparing liquid assets or current assets with current liabilities.

How do bid-ask spreads and price impact differ?

The bid-ask spread is a visible transaction cost of immediate trading. Price impact measures how much an order changes the market price, making it particularly relevant when assessing the capacity to trade in size.

Sources

• Measuring Liquidity in Finiancial Markets - WP/02/232 — www.imf.org
• Market liquidity: A primer — www.brookings.edu
• Understanding Liquidity and How to Measure It — www.investopedia.com
• Global liquidity indicators - overview - BIS Data Portal — data.bis.org