Liquidity is the ability to buy or sell an asset rapidly in the market without affecting its price. Liquidity is important for efficient market functionality as it allows investors to enter and exit positions with ease and ensures businesses are able to meet their short-term obligations.
Three types of liquidity are market liquidity, asset liquidity, and accounting liquidity. Liquidity in trading can be measured or calculated using the current ratio, quick ratio, or cash ratio.
Examples of liquidity are cash, government bonds, blue-chip company stocks, money-market instruments, and Exchange-Traded funds (RTFs).
What is Liquidity?
Liquidity is the ease and speed with which an asset or security can be converted to cash or another asset. Liquidity indicates the marketability and salability of an asset at its fair market value with minimal loss in value. High liquidity means an asset has high demand and is easy to sell in the open market.
Liquidity in finance refers to how easily and quickly an asset or financial instrument can be bought or sold in the market without negatively affecting its market price. Examples of liquid assets in finance include cash, stocks of large blue-chip companies, and government bonds. Less liquid assets in finance include tangible items like real estate, private equity, collectibles, and fine art.
Liquidity in accounting refers to a company’s ability to meet its short-term obligations (those due in a year) with its available liquid assets. Liquidity definition in accounting is usually expressed as a ratio or percentage of the current liabilities.
Liquidity is an important Forex trading term used by Forex traders to identify the supply and demand dynamics in different currency markets.
What is Liquidity in Forex Trading?
Liquidity in Forex trading is the ability of a currency pair to be sold or bought without significantly impacting its exchange rate. Forex trading requires active buyers and sellers to complete a transaction. High liquidity in trading means there are many willing buyers and sellers in a currency market, allowing traders to open and exit positions quickly without affecting the currency pair’s price.
Liquidity in Forex trading increases or decreases depending on the trading activity of the currency pair. Higher trading volume leads to a deep market with buy and sell orders at various price levels, making it easier for trade orders to find counterparties and get filled close to the current price.
High trading liquidity results in tight bid-ask spreads because market orders are executed quickly and close to each other, ensuring low trading costs for traders. Forex traders prefer placing trades on major currency pairs such as EUR/USD, GBP/USD, and USD/JPY because these currencies are involved in major international trade and settlements and experience high trading volumes.
Trading without liquidity in the Forex market is possible but very challenging and risky. Low trading liquidity results in high volatility in the currency markets, where even small market orders cause huge price fluctuations. Market participants avoid less liquid currencies in Forex trading, forcing brokers to widen the bid-ask spreads and increasing the cost of opening and closing trades.
Trading without liquidity exposes traders to slippage when trade orders are executed at price levels different from expected. Slippage occurs because there are fewer active buyers and sellers, making it difficult for trades to get filled close to the current market price. Examples of low-liquidity currency pairs include exotic currency pairs like USD/ZAR, EUR/TKR, and USD/NOK.
The “Forex trading definition” of liquidity is commonly used by traders during peak market hours, such as the London-New York overlap session, when trading volume is highest.
Trading liquidity is vital for traders, investors, and businesses because it helps them make informed decisions when outlining their strategies.
Why is liquidity important?
Liquidity is important because it affects the day-to-day operational efficiency of financial institutions, businesses, and individual traders. Liquidity enables businesses to pay their short-term obligations like bills, salaries, and outstanding debts and provides a safety net for periods of economic uncertainty like recessions. Liquidity in Forex trading and financial markets is important for faster order execution and increased market efficiency.
Liquidity helps manufacturers and service providers manage their cash flow and meet daily expenses. Liquidity influences how businesses spend money and determines whether an institution can seize emerging opportunities like investments and acquisitions. Small business owners strive to maintain high liquidity because it is a reliable financial cushion during economic downturns and crises. Banks and investors look for businesses and industry players with positive liquidity and good financial discipline to determine their creditworthiness when offering credit.
Liquidity in financial markets ensures stability by facilitating price discovery where exchange rates reflect true supply and demand, thanks to the many buyers and sellers. High market liquidity helps reduce volatility caused by single buyers and sellers, leading to stable markets and increased transaction volume.
For instance, the U.S. dollar, euro, and Japanese yen were the most liquid currencies in Q4 of 2023 and experienced the highest volumes of credit borrowing transactions, according to BIS. The BIS data reveals that financial institutions completed credit transactions in USD and EUR because of the monetary tightening policies employed by the Federal Reserve (Fed) and European Central Bank (ECB), leading to higher interest rates. Financial institutions shunned offering credit in Yen because the Bank of Japan resolved to keep their interest rates below zero, leading to a relatively more unstable market than the dollar or euro.
Liquidity in Forex trading allows for quick execution of buy and sell orders and narrower spreads, leading to lower trading costs and increased trading activity. Investors are attracted to liquid markets because of their ease of conducting transactions and resilience to financial shocks or economic crises.
How does liquidity work?
Liquidity refers to the ease with which an asset can be bought or sold in the market without resulting in a loss in value. Liquidity measures how fast a seller converts a tangible asset into cash or how fast a buyer transforms cash into a tangible asset. Liquid markets have a high supply of buyers and sellers, meaning the supply and demand for an asset is high.
Cash is the most liquid in finance because it is widely accepted for transactions and does not lose value. For instance, a business looking to purchase inventory worth $10,000 using cash on hand completes the transaction directly. The value of $10,000 is guaranteed and does not change with time. The same business may have a problem if they need to sell some stocks to raise money to buy the inventory. The stock-selling process may take time, and the stock prices might fluctuate, meaning the business could end up with less than the $10,000 needed if the stock price declines.
Liquidity in financial markets involves marketable assets such as currency pairs, bonds, or stocks. Traders and investors place buy and sell orders through electronic broker platforms, and brokers complete transactions by matching the buy orders with the sell orders. Brokers and trading exchanges use order books to record the buy and sell orders placed at different price levels alongside the volume of the orders.
A market with many participants is highly liquid because it increases the chances of trades finding their counterparty. Some exchanges and brokers, known as dealing brokers or market makers, help provide liquidity in financial markets by always taking the opposite side of their client’s trade.
Liquidity is affected by factors such as economic events, investor sentiment, and market regulations. Economic events such as geopolitical tensions and natural disasters increase market volatility and affect market sentiment. Investors avoid such markets, making them illiquid.
What are the different Types of Liquidity?
The different types of liquidity are listed below.
- Market liquidity
- Asset liquidity
- Accounting liquidity
1. Market Liquidity
Market liquidity is the ability to purchase or sell an asset at a fair price and quickly without impacting its price. Market liquidity focuses on speed, volume, and transaction costs to determine whether a financial market is liquid. Market liquidity ensures that assets can be sold quickly at any time within market hours and at a stable price.
High market liquidity occurs when there is a large pool of active buyers and sellers in the market, making transactions easier and more efficient. Market liquidity is commonly experienced in the interbank market (for Forex) and on exchanges like stock exchanges and bond exchanges where liquid assets are traded. The United States is the top contributor to market liquidity in the world.
Low market liquidity means there are few market participants, making it harder to sell or buy an asset. The bid-ask spread in low market liquidity conditions is usually widened, compared to periods of high market liquidity when spreads are narrow.
2. Asset Liquidity
Asset liquidity is the ability to convert an asset into cash quickly without losing value. Assets that are faster and easier to convert to cash experience higher liquidity because of a high demand from a wide pool of willing buyers and sellers. Cash experiences the highest asset liquidity because it is accessible and globally accepted as a means of exchange.
Asset liquidity affects cash equivalents such as Money Market Funds and Treasury Bills (T-bills), accounts receivable, inventory, and marketable securities such as blue-chip stocks and government bonds. The United States is the top contributor to asset liquidity in the world.
Assets experience high liquidity when the organization or economy is doing well. During economic downturns and recessions, investors avoid risky assets like stocks or real estate and hold on to cash. Changes in investor sentiment result in low asset liquidity, meaning markets have fewer market buyers and sellers, making it hard to convert assets to cash.
3. Accounting Liquidity
Accounting liquidity is the ability of a company to fulfill its short-term debts and obligations using its current assets. Companies calculate their accounting liquidity by comparing their liquid assets to their current liabilities.
Current assets for a business include cash on hand and cash equivalents, accounts receivable, checking and savings bank account balances, and marketable securities. Business current liabilities include accounts payable, short-term debt, accrued expenses, income taxes payable, and the current portions of long-term debt.
Accountants and business analysts use ratios such as current ratio, quick ratio (acid-test ratio), and cash ratio to calculate accounting liquidity.
Accounting liquidity helps businesses improve their creditworthiness, provides financial and strategic flexibility, and helps manage risk.
How to Measure or Calculate Liquidity?
The three ways to measure or calculate liquidity are listed below.
- Current Ratio
- Quick Ratio
- Cash Ratio
1. Current Ratio
Current ratio is a simple measure of a company’s ability to pay its short-term obligations. Current ratio is obtained by dividing the current assets by the current liabilities.
The formula for calculating current ratio is Current Ratio = Current Assets / Current Liabilities.
A current ratio above 1 suggests that a company has more assets than current liabilities, indicating a highly liquid company. For example, a company with current assets worth $10,000 and current liabilities worth $4,000 has a current ratio of $10,000 / $4,000 = 2.5.
Banks, investors, and lending institutions often look for ratios above 2:1 as a sign of a healthy company.
2. Quick Ratio
Quick ratio, also known as the acid-test ratio, is a strict measure of liquidity that excludes inventory and any prepaid expenses from the calculation of the current ratio because these assets experience varying liquidity. Quick ratio includes more liquid assets like cash, marketable securities, and accounts receivable.
The formula for calculating quick ratio test is Quick ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities.
A quick ratio above 1 suggests that a company has more assets than current liabilities, indicating a highly liquid company. For example, a company with cash at hand worth $10,000, marketable securities worth $2,500, account receivables worth $2,500, and current liabilities worth $8,000 has a quick ratio of ($10,000 + $2,500 + $2,500) / $8,000 = 1.875.
Lending institutions and business analysts consider quick ratios above 1.5:1 because of the conservative guidelines.
3. Cash Ratio
Cash ratio is the most conservative liquidity measure that measures the ability of a company to meet its short-term obligations using cash and cash equivalents. Cash ratio excludes any assets that may take time to convert to cash, such as inventories or accounts receivables.
Cash ratio is obtained by dividing cash and cash equivalents by the current liabilities. The formula for calculating cash ratio is Cash Ratio = Cash and Cash Equivalents / Current Liabilities.
A cash ratio above 1 indicates the company’s ability to pay its debts or unexpected expenses without resorting to inventory sales or collecting accounts receivable. For example, a bakery with cash at hand worth $5,000, marketable securities worth $2,500, account receivables worth $2,500, and current liabilities worth $8,000 has a cash ratio of $5,000 / $8,000 = 0.625.
How does liquidity affect Financial Markets?
Liquidity affects financial markets by impacting the returns and profitability of investments made by individual investors or pension funds and affecting the costs of international dealings for businesses and governments. Liquidity in financial markets ensures efficient price discovery and market stability, reduces transaction costs, enhances market depth, helps with risk management, and boosts investor confidence.
High liquidity in financial markets leads to smooth and predictable trading performance because investors can enter and exit positions without affecting the asset’s market price. Reduced liquidity results in wild price fluctuations, making purchasing or selling assets difficult and affecting the returns of pension funds, hedge funds, mutual funds, and individual traders.
Businesses, corporations, and governments involved in international trade are affected by liquidity when it influences currency exchange rates. High liquidity leads to stable financial markets since liquidity works as a buffer during financial crises, resulting in predictable exchange rates, which is good for business. Low liquidity, on the other hand, results in increased market volatility and makes it difficult to predict exchange rates for international transactions.
Market liquidity in financial markets reduces transaction costs for traders and investors by offering tight bid-ask spreads, attracting more market investors. The new investors looking to participate in the trading activity contribute to asset liquidity and increase market depth.
High liquidity allows traders to adjust their trade positions quickly in response to market conditions, enabling them to manage risk effectively. Traders and investors get more opportunities for hedging to diversify their risk, thereby reducing the potential losses.
Investors and traders gain more confidence in liquid markets because liquidity signifies a healthy economy and stable business. High liquidity often correlates with bullish investor sentiment, while low liquidity contributes to bearish trends.
How do Liquidity and Forex Brokers smoothen Forex Market efficiency?
Liquidity and Forex brokers smoothen Forex market efficiency by facilitating market access, providing competitive pricing, ensuring efficient order execution, offering depth of market information, and improving risk management tools. Forex brokers and liquidity providers employ techniques like liquidity aggregation, market making, and order book management, which contribute to a more efficient market.
Forex brokers facilitate market access by providing trading platforms for retail and institutional traders, offering traders all the top technical tools and indicators. Liquidity providers and some brokers act as market makers by taking the other side of trades. Market-making facilitates the flow of orders, including during periods of low liquidity, ensuring a smooth trading experience.
Liquidity providers and Forex brokers provide competitive pricing in trading using techniques like order aggregation, where Forex brokers consolidate multiple buy and sell orders for a particular currency pair from their clients using a foreign exchange aggregator. Once the order pool becomes large enough, they execute the trades in the interbank market as one order.
Forex order aggregation is often implemented by Tier-2 liquidity providers who do not have direct access to the interbank system. Liquidity aggregation allows brokers to attract many liquidity providers, including Tier-1 liquidity providers, who offer better pricing, leading to faster order execution and tighter spreads for their clients. Tier-1 liquidity providers include big banks and financial institutions like JP Morgan Chase, Deutsche Bank, and Barclays Bank, which have access to the interbank market. Tier-2 liquidity providers are smaller institutions like regional banks, mid-sized Forex brokers, and other small financial institutions that source liquidity from Tier-1 providers and offer it to Forex brokers at slightly wider spreads.
All Forex brokers have access to at least one Tier-2 liquidity provider. Some of the top Forex broker platforms, such as Saxo Bank or Interactive Brokers, also have access to Tier-1 liquidity providers.
What are the best Liquidity Providers for Forex Brokers?
The best liquid providers for Forex brokers include FXCM PRO, B2Broker, and Swissquote. FXCM PRO, B2Broker, and Swissquote are Tier-2 liquidity providers, meaning they do not have direct access to the interbank market, but they aggregate their liquidity from multiple sources like Tier-1 banks, ECN brokers, and non-bank liquidity providers, ensuring deep liquidity across various instruments.
FXCM PRO is a highly reputable liquidity provider for institutional and retail clients, offering deep liquidity, competitive pricing, advanced trading technology, and robust risk management solutions.
B2Broker is a leading liquidity and technology provider specialized in Forex and cryptocurrency markets. B2Broker serves a wide range of clients, including brokers, hedge funds, banks, and professional traders.
Swissquote is an established Geneva-based financial services provider that offers a range of banking and trading services, including Forex liquidity provision. Swissquote is among the best Forex liquidity providers, known for its robust technology, regulatory compliance, and a wide array of financial products and services.
Does Market Liquidity Affect Market Volatility?
Yes, market liquidity affects market volatility. Market liquidity and market volatility share an inverse relationship where high liquidity results in reduced volatility and stable markets, while low market liquidity results in high volatility and wild price fluctuations. The reason for the inverse relationship is the number of buyers and sellers in the market.
Highly liquid markets have a large and diverse pool of buyers and sellers, ensuring there is always a counterparty for trade. More market participants make it easier to absorb buying and selling pressure or erratic price moves, resulting in low market volatility. Effective liquidity management mitigates market volatility.
Less liquid markets are volatile and experience large price fluctuations because fewer market participants are available to take the other side of the trade.
What are Examples of Liquidity?
Examples of liquidity are listed below.
- Cash: Includes physical currency and money held in checking accounts, savings accounts, or other types of deposit accounts.
- Government bonds: Include Short-term and medium-term government securities traded in active markets.
- Stocks of large, blue-chip companies: Include Apple (AAPL), Microsoft (MSFT), Alphabet (GOOG), Procter & Gamble (PG), and Coca-Cola (KO).
- Major currency pairs: Include EUR/USD, GBP/USD, USD/JPY and USD/CAD.
- Money market instruments: Include Treasury bills, certificates of deposit (CDs), and commercial paper.
- Exchange-Traded Funds (ETFs): Include investment funds that trade on stock exchanges and hold assets such as stocks, bonds, or commodities.
Cash is the most liquid asset in finance, followed by cash equivalents like Money Market Funds, Treasury Bills (T-bills), Certificates of Deposit (CDs), Repurchase Agreements (Repos), and short-term bonds.
Is liquidity always cash?
No, liquidity is not always cash. Cash is the most liquid form of liquidity because it is readily used to complete immediate transactions without losing value. Other assets can be converted to cash quickly, making them highly liquid, such as marketable securities like stocks and bonds or cash equivalents like money market instruments.
Liquidity also exists in assets that are difficult to convert to cash, such as inventory, real estate, and private equity holdings. Liquidity can be how fast it takes to convert one asset into another.
Are all assets considered liquid assets?
No, not all assets are considered liquid assets. Liquid assets refer only to assets that can be exchanged for cash or its equivalent quickly without significantly affecting their price. Examples of liquid assets include cash and its equivalent, government bonds, stocks, commercial paper, and treasury bills.
Non-liquid assets refer to assets that cannot be easily bought or sold without significantly affecting their market price. Examples of non-liquid assets include real estate, art and collectibles, private company shares, and complex financial instruments like exotic derivatives or structured products.
Does liquidity cause Slippage to Occur?
Yes, low liquidity plays a role in causing slippage. Low liquidity markets often do not have enough buy or sell orders at the current market price level to fill large and sometimes small order sizes, causing the order to be executed at different prices than expected. The high volatility experienced in illiquid markets leads to slippage as the market adjusts to accommodate new orders.
High market liquidity provides adequate buyers and sellers in a market, meaning trade positions find counterparties easily. Market orders are usually executed at the current market price instead of unfavorable price levels, which is the “slippage definition”, when the price is filled at a different price from the requested price.