Liquidity is application to assets, markets, and businesses. Each carries a bit different meaning.
Overall, liquidity is how quickly an asset can be converted into cash. This is based upon market dynamics and how much activity is related to it. Those without a lot of transactions are considered non-liquid. This often results in a wide spread between the bid-ask prices.
It is vital for markets to have liquidity so that participants can enter and exit securities as they desire.
Cash is considered the most liquid asset. Real Estate and land are illiquid since it can take weeks or month to sell.
Business Liquidity
For a business, liquidity refers to the ability to convert assets to cash or acquire the cash needed to meet short-term liabilities and expenses.
Profitable businesses tend to have a lot of cash or cash equivalents on their balance sheet. When dealing with liquid securities such as US Treasuries, a firm can access the cash rapidly.
Analysts and investors are regularly asking how much cash could a company raise, and how quickly, if it needed to pay everything off. The answer to this shows how liquid a firm is.
Banks focus upon this when it comes to making loans. The financial institution is looking to ensure the payments on the debt can be made. If there is distress, can cash be raised to continue meeting the obligation?
This is assessed by looking at the assets of the firm:
- Currency Assets: cash is at the top of the list. Others include ones that are less liquid since they must be sold but tend to have a market.
Examples are:
- marketable securities
- accounts receivable
- inventory
- prepaid expenses
While the assets might need to be discounted, then can be turned into cash in a short period of time (usually less than 30 days).
- Fixed Assets: these are less liquid because they normally take months, if not years, to sell. An example is buildings or equipment. Fixed assets are also a problem since the firm usually requires them for normal operations. Selling a plant that is manufacturing a product that is sold into the marketplace is not a great way to raise capital.
Ongoing business activity can affect the liquidity of a company. Double entry accounting means that a change in the ledger results in a corresponding move.
For example, if cash is used to buy inventory, which is sold at a profit, that can increase the liquidity. The reverse is cash used to buy land, something that decreases it.
The caveat is something that is purchased using debt. Under general accounting rules, only the current portion affects liquidity. After a year, it goes under long term liability, actually increasing the liquidity.
Market Liquidity
In markets, liquidity involves the trade-off between the price at which an asset can be sold, and how quickly it can be sold. When something needs to be sold quickly, the price often is discounted if the market is not liquid.
One of the key factors with liquidity is speed. This distinguishes it from depth, which deals with quantity at certain price levels.
A key characteristic to a liquid market is one where that are plenty of both buyers and sellers willing to engage in transactions.
There are a few factors that enhance the liquidity of an asset's market.
speculation - traders and investors seek to profit from moves in price. This brings them into the market, especially when a perceived discount is being offered
market maker - these institutions that engage in buying and selling to ensure there is always the opposite side of a trade. Investment banks sometimes use their own balance sheets as a means for entering the market. More often, they serve as intermediaries, charging a commission for keeping the market liquid.
arbitrage - here is where different exchanges are traded, taking advantage of price differences. By selling on one and buying on another, both receive activity.
Great Financial Crisis
A lack of liquidity can have horrific consequences. When the markets are large enough, it becomes a systemic risk.
The Great Financial Crisis is an example.
Originally, this formed when people saw a problem in the subprime mortgage markets. These were high risk mortgages that were given to borrowers who had lower credit ratings. In exchange, they ended up being charged more fees and a higher interest rate.
These loans were sold by the originators to Wall Street firms. They broken up, repackaged, and sold into the market as fixed income instruments. The Wall Street rating agencies put them on par with Treasury bonds.
The assets were then used by the financial system as collateral. This was big in the global short-term lending market, also known as the Eurodollar System. The collateralized lending reached epic proportions as the volumes kept increasing.
Everything started to come into question when BNP Parabas had trouble valuing a number of its funds. The liquidity on the mortgage backed securities (MBS) that were in them dried up. It took them three days to price the assets in the fund.
What ensued was a bank run albeit not in the traditional sense. The systemic risk resulted in all starting to analyze what they were holding. Major counterparty risk was realized after the hedges put in place were found to be worthless.
The entire mess ended up at the door of AIG, requiring a bailout from the US government.
Liquidity often dries up during market declines as buyers exit the market. This leaves sellers having to discount prices even further to unwind positions, further accelerating the drop.