Liquidity is the key to market performance. Let’s see why it is so important.
We are witnessing a forced reduction of liquidity on the markets and this must make us reflect on the importance of this element within the financial markets. An expansion or reduction of the same entails profound changes in the structure of some markets and implies consequences that are fundamental in the long-term movements of some sectors of the financial world.
Obviously, the central banks regulate liquidity and, at a later stage, the allocation of the liquidity is up to the operators who decide where to invest based on the risk of each sector. At this historical moment we have a reduction in liquidity on a global scale, therefore it is absolutely necessary to make some notes about its significance and its importance within the financial markets.
Liquidity: what it is and why it is important
In academic contexts, liquidity is spoken of as one of the characteristics of an efficient market. A market is efficient when there are many trades on each price level and this is guaranteed by the strong presence of liquidity. The liquidity is none other than the availability of money of the operators, which leads to a increase in trading on each price level and consequently involves the correct functioning of the market, i.e. meeting of supply and demand on every price level of every market.
Imagine a market full of traders trading stocks (or contracts) in large volume on any price level, basically an active market that satisfies the needs of supply and demand. Now imagine a market where there are few operators, where exchanges are few (or almost zero), where the needs of those who want to buy or sell at a certain price are not met. In this regard, the needs of operators are to negotiate a certain quantity at a certain price, therefore in a market that is not very liquid this cannot happen. Therefore liquidity determines the quality of a market and consequently its risk. For example, a very liquid market is by definition not very risky as it will not be subject to huge price fluctuations due to any market “gaps”, ie price levels where there are no operators.
A liquid market is therefore a market full of trading volumes and operators, therefore it will be seen as a healthy market that guarantees entry and exit from it in a completely "safe" way. An example of very liquid market is the currency one, the Forex, which by definition is the most liquid market there is since one currency is exchanged for another. Another very liquid market is that of bonds and government securities to then scale to less liquid markets, which in any case have enormous trading volumes, such as the futures market on stock indices and commodities. In practice, the most traded markets are also the most liquid and the most efficient markets.
Liquidity and risk
This aspect is fundamental. A very liquid market is usually associated with a low level of risk, why? The reason is very simple and derives from the fact that prices move less quickly as on each price level we can easily find supply and demand that manage to "stop" the market. If we pay attention Forex, which is the most liquid market of all, is the market that presents percentage changes that are significantly lower compared to a small cap stock, a stock that has absolutely less liquidity than to Forex. Therefore, less liquid correspond to larger market fluctuations and consequently greater risk. The higher the liquidity there are smaller market fluctuations and consequently a lower risk. Beware, these were examples of how liquidity works within a specific financial market. But how does liquidity work within the global financial system?
Cash and central banks
Central banks regulate liquidity within the global financial market by raising or lowering interest rates. An increase in interest rates leads to a decrease in liquidity on a global scale, a reduction in trade and a lower efficiency of the financial markets. This is basically the photo of the current situation where we have all the central banks of the most important economic areas that are increasing the cost of money, thus increasing the cost of liquidity.
In practice, there is currently a reduction in liquidity and therefore we can justify large increases in volatility within the financial markets, with stock markets collapsing, bond markets emptying out of traders to offer better returns. Forex is undergoing major adjustments in the long term and the commodity market is highly dependent on the trend of the dollar, the reference currency for global commodity trading. In this context, therefore, we see the liquidity crisis as the sole cause of the strong movements we see and, considering the current situation at the macroeconomic level, further increases in interest rates could lead to an exacerbation of these movements in the long term.
In practice, the reduction of liquidity on a global scale will lead to a decrease in the efficiency of the markets, a decrease in trading and an increase in fluctuations on different markets. This inevitably leads to major adjustments that will have to take a long time before we see their realization, so we could see further downturns in the financial markets in the next year. Subsequently, when central banks understand that they will be able to grant liquidity to the market again, we could speak of a return to normal.
Original article published on Money.it Italy 2022-11-15 08:57:00.
Original title: Perché la liquidità è importante per i mercati
