A Dive into Liquidity: Basic Terms, Types, and Calculations
Investors understand liquidity as a core factor that shows whether to buy/sell certain assets or not. Let's dive into this notion to comprehend its importance better.
What is the meaning of liquidity?
In simple terms, liquidity shows whether it is possible to buy and sell an asset by its market price. Cash has absolute liquidity, serving as a benchmark for other financial instruments - holders of fiat currencies may exchange them for other currencies or for goods/services.
In the hierarchy of liquidity, assets may have different liquidity in general or inside a class. For instance, stocks are more liquid than real estate while comparing two classes; meanwhile, a gorgeous villa owned by Donald Trump is more liquid than stocks of a company undergoing hard times.
The liquidity notion is clustered into two key subcategories: market and accounting liquidity. What do these subcategories mean?
Market liquidity (ML)
Market liquidity refers to how in-demand a certain market is among buyers and sellers. Let's imagine the situation when an owner of an art masterpiece wants to exchange it for a car. Such ""transactions"" are possible, but not common; this is why the market is illiquid. On the contrary, investors are interested in purchasing and selling stocks, real estate, cryptocurrencies, and those markets are liquid enough.
The ML directly depends on spreads. The lower spreads are, the more liquid markets are. For instance, an investor wants to buy Bitcoin for $60 000, and a crypto holder is ready to sell 1 BTC for this price; this is why a spread, the difference between the bid and ask requests) is 0 which makes a market highly liquid.
While talking about other assets like commodities, derivatives, stocks, etc. the market liquidity is impacted by many factors: the market size, trading volumes, the number of platforms available to buy and sell assets, etc.
Accounting liquidity (AL)
Accounting liquidity is a term referring to companies and their possibility to pay off current debts.
From the viewpoint of investments, the AL takes into consideration a company's liquid assets and current liabilities and obligations to come due within 12 months. The accounting liquidity is usually measured by different formulas, including Current Ratio, Quick Ratio, Acid-Test Ratio, and Cash Ratio. What do those formulas mean?
Current Ratio is the simplest way to evaluate a company's financial situation, as the formula divides current liquid assets by liabilities and obligations.
Quick Ratio takes into account a company's cash, cash equivalents, short-term investments, and accounts receivable to understand the financial situation from the other side. The Acid-Test Ratio subtracts inventories and prepaid costs from current assets.
As for the Cash Ratio index, the formula divides only cash + cash equivalents by a company's liabilities and obligations.
The herein-given formulas let investors understand the AL of a company to evaluate it fairly, considering the interconnection between assets and liabilities.
Examples of market liquidity
While talking about investments, assets are not equally liquid inside a certain category. For instance, one equities are more liquid than other representatives of this class. The same situation happens in other markets. Let's dive into the liquidity of different classes to understand how to calculate liquidity for FX, equities, cryptocurrencies, ETFs, and other financial instruments.
The notion of Forex liquidity is rather a controversial issue, as cash is considered the asset with the highest liquidity. On the other hand, some trading pairs turn out more liquid than others. As for traders, the market functions as CFD contracts; this is why users are not obliged to purchase underlying assets. When they buy one currency, another currency is automatically sold (e.g., CHF/USD).
Liquidity is provided by market makers (large banks, hedge funds, investment funds, etc.) but Forex brokerage companies cannot work with those players directly. This said liquidity providers come into the light. LPs are companies that connect brokers to liquidity pools and make it possible for brokerage companies to execute clients' bid and ask orders instantly.
Digital currencies constantly set new records, and the crypto market capitalization has jumped over the level of $2.5 billion. More than 300 million people globally hold digital assets, and with the increasing accessibility of cryptocurrencies, the audience is on the rise. While diving into the crypto market, liquidity is incarnated in several faces:
Asset liquidity. Some cryptocurrencies are more liquid than other digital assets. Calculate an asset's liquidity with the help of a cryptocurrency's price and its 24h volume. For instance, the liquidity of Cardano (1 056 751 501 ADA per 24 hours) is higher than the liquidity of Bitcoin (464 309 BTC).
Exchange liquidity. When a new trading platform comes to the market, traders focus on its 24h trading volumes. The higher volumes are - the better. For newcomer platforms that becomes a problem. Liquidity aggregators help beginner business owners connect their exchanges to liquidity pools where other crypto exchanges take place. As such, trading volumes of several platforms are gathered together and displayed for every crypto exchange.
The market of equities has much in common with the liquidity of digital assets, as one equities are more liquid than the other. Diverse factors impact their liquidity, including the interest of investors, a company's reputation and goals, etc.
For instance, Apple shares (AAPL) are highly liquid with daily trading volumes of $58.8 million; meanwhile, the shares of Intel Corporation (INTC) are traded for $109.97 million within 24 hours. Eventually, Intel shares are more liquid than Apple ones, despite the fact that Apple leads the market, according to market capitalization.
While talking about the liquidity of equities, we need to say some words about ETF liquidity, as shares of ETF funds are traded on exchanges. Meanwhile, there are some differences with equities:
If ETF shares are in high demand, some additional stocks are issued to the market. Investors may focus on their trading volumes, but the index is not crucial.
The ETF liquidity mainly depends on underlying assets (cryptocurrencies, metals, stocks, etc.).
Why is liquidity the core characteristic for investors?
Investors who are going to purchase some assets need to take liquidity into account, as this notion shows whether it would be possible to purchase assets by their market prices or to convert them into other assets. Invest your money into liquid assets, as illiquid markets are considered the ones with the highest risks.
B2Broker, a liquidity provider for key financial instruments
As for brokerage companies, crypto exchanges, ETFs, and other players where investors/traders buy and sell assets, liquidity is among the crucial factors from the viewpoint of their opportunity to overrun competitors. B2Broker is a company that provides access to the largest liquidity pools for Forex and crypto brokers, exchanges, and other companies.