UsableMarkets

Anyone who designs a market, or participates in a market, at some point or another probably has to deal with the language of the market. Even eBay (admittedly not the poster boy of easy-to-use markets) has a glossary for its users. UsableMarkets, in an (desperate) attempt to provide some sort of public service, will endeavor to take some of the more difficult concepts of markets and explain them in an easy-to-understand manner.

So, without further adieu, a term that seems to be everywhere these days: liquidity.

First, the proper definition of liquidity from InvestorWords.com (a great reference site, btw):

The ability of an asset to be converted into cash quickly and without any price discount.

Sounds simple, right. You probably don’t even need to read on, but (for the hell of it) let me break it down to the elemental pieces.

A. Liquidity is about converting an asset (whatever it is, bond, stock, Tickle-Me-Elmo, etc.) into cash.
It is not about the volume of a market (the number of trades that are happening in a market). Nor is it about the number of traders that are in the market (although more traders often equals more liquidity). It is about me getting cash for my precious goods.

B. The asset can be easily converted.
In other words, I don’t have to wait around to find someone to convert … er … trade with me. This is generally considered a very good thing for markets, because it means I’ll probably get a fair price for what I’m trying to sell.

C. Converting an asset doesn’t reduce the value of it.
This is a bit harder to wrap your head around, but it essentially means that you aren’t being forced into unreasonable prices. For example, if I sell something at $1, and then can only buy it back (moments later) at $10, I took quite a discount in price for my asset by selling it. This brings us to the concept of the spread … but that’s a term for a later day.

Wikipedia’s definition of liquidity is a bit more expansive, and it introduces some additional concepts surrounding liquidity. Wikipedia defines it as:

an asset’s ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value.

We’ll ignore the mention of “buying” in Wikipedia’s definition, but it does bring up an important fourth concept:

D. Converting an asset doesn’t greatly change the current price of that asset.
In other words, my transaction doesn’t make everyone go crazy and start selling at prices wildly different from the prices of that asset just before my transaction. In other words, I didn’t sell it (and someone didn’t buy it from me) at a ridiculous price that then changed everyone’s opinion about the value of that asset.

Those of you who are following the financial markets may be hearing the phrase “a crisis of liquidity” as an explanation for the recent market gyrations. What is essentially being referred to is that specific types of transactions in the credit and money markets are failing the definition of liquidity, particularly concepts B, C and D referred to above.

In other words:
- people are having a hard time finding buyers for their assets (“come on, please take this obscure financial product made up of different types of bonds”)
- the people buying these products (investors) aren’t offering very good prices for them (“you’re offering me how little?!?!”)
- for trades that do happen, they are happening at prices that are making the other people nervous (“Joe sold his at that price?!?!? Holy $%*#! I’m up the creek!”)

Make sense? I know, clear as mud.

Next week, undaunted, I’ll tackle the term: shorting

Liquidity … it’s just underneath that wave!

As always, thanks for listening.
~alex