Why is liquidity important?

Now you would think this was an easy question, or at least I did. However, the once unquestioned value of liquidity to markets is now being knocked of its perch by politicians and people fazed by the current economic crisis.

One of the worst things anyone can do in a crisis is to panic, but that appears to be the case today. Research has shown that many people just don’t get the importance and value of liquidity to the market. Primarily this is because of the popular pastime of banker bashing and a distinct lack of knowledge of how the financial markets work. But this is also the fault of a finance industry that continues to propagate greed and ignore the deep mistrust society currently has of the Financial Services Industry in general. Neither is really an excuse for not understanding the basics of what the financial markets need.

Any market will struggle if it doesn’t have sufficient products, buyers and sellers. For example; if there was only one producer of cars, then car prices would be higher, as the manufacturer could charge whatever it liked, until new competition emerged to create more choice and also liquidity in the market for purchasers.

Continuing this theme, if you wanted to buy a particular car but you only had access to one retailer but it did not have the car in stock, you couldn’t get that car. However, if you had access to multiple retailers and they had access to lots of different sources you would not only be able to acquire the car you wanted, but you would be able to buy at the best price.  This is liquidity, so liquidity in any market is all about choice and the ability to fulfil orders.

The alternative to liquidity is to try and match an order. For example, there are a limited number of retailers who have the model of car you want. You go to one of them but they cannot offer you a car at the price you want to pay but given time will try to acquire the car at this price for you. The problem is you will have to wait and indeed unless the retailer can find a car at a price to make a profit or at the very least cover their costs; you may not actually get your ordered fulfilled. This is called an illiquid market.

What way of trading do you think is best?

In the securities markets there are two basic ways of trading; one is a matched order and the other is quote driven. The matched order is illiquid and expensive, leaving potential dissatisfaction of buy or sell orders. The quote driven is a risk based market where the wholesaler will contract to sell and ensure delivery by borrowing stock. They will be continuously buying and selling, creating liquidity for any investor wishing to buy or sell, knowing that their orders will be executed.

So why is there any doubt about the importance of liquidity to the market?

All this and more will be discussed by Lord Vinson and Frank Field MP, in debate with Anthony Belchambers, CEO, Futures and Options Association and Nicolas Bertrand from the London Stock Exchange, on the 22nd February at the forthcoming Post Trade Forum, hosted by the London Stock Exchange. Preceding the debate will be a presentation on the importance of stock borrowing for liquidity in the market.