Understanding Liquidity

The following is not financial or tax advice. Please consult a CPA or investment professional before making tax or investment decisions.

What is easier to sell quickly, with lower transaction costs, and close to the last price you see on your trading screen, a bond issued by Senegal, or Microsoft stock? A PSA graded 7 Nolan Ryan rookie card or an ounce of gold? In both cases the answers are obvious (Microsoft stock and an ounce of gold). The ability to convert an asset to cash quickly with little change in the market price is called liquidity. The quicker you can turn an asset or item into cash without changing the price the asset/item trades at, the more liquid it is. Liquidity is like air, you don’t notice it until you don’t have it and it quickly becomes a really big problem.

Determinants of Liquidity

• Number of market participants
• Size of market participants and institutional constraints
• Availability of and access to capital
• Transaction costs
• Ease of transacting
• Presence/absence of active market makers
• Policy constraints
• Counterparty risk

Number of market participants

As a kid I used to collect insulators, which are what they sound like, heavy pieces of glass or ceramic that are used on electrical and telephone poles to hold wires. I used to either cut down old telephone polls (without wires) or climb them to get the insulators. It was ridiculously dangerous and stupid in retrospect, but I still have all of my fingers and toes.

For all my dangerous efforts, I got insulators which are about as niche as a collector’s item as you can get. The group of people collecting insulators, even in the internet age is small (less than 10k people) relative to other collectibles. As a result, there are not a huge number of people that want to buy insulators. If you want to sell insulators, your market is inherently tiny. Not only will it be hard to sell all but the most valuable insulators, but you will likely have to significantly reduce the price you are selling at relative to whatever price a price guide is showing you. Compare insulators with baseball cards. There are millions of people who own and sometimes buy or sell baseball cards, the market is therefore a lot more liquid.

In the financial market the same axiom holds true, the greater the number of participants, all else being equal, the greater the liquidity. A large capitalization US stock such as Alphabet is present in tens if not hundreds of millions of accounts and is actively traded by every major financial institution in the world. An Over The Counter (OTC) stock may not trade for days and the next trade can potentially be wildly different than the previous.

Size of market participants and institutional constraints

Combine the capital of all the baseball card shop owners in the world and compare it to JP Morgan Chase, which one do you think has more capital to buy and sell? Large institutions have really deep pockets that allow them to trade billions. To move the needle on their earnings these institutions have to invest huge amounts of money. As a result, any market that large institutions such as prime brokers, hedge funds, market makers, and asset managers participate in will likely be highly liquid. Conversely, a smaller security will not attract the attention of these large institutions as they cannot move the needle by trading them so they inherently have less liquidity.

Availability of and access to capital

In addition to the size of the participants, access to capital is a function of central and private banks activity. To grossly simplify, when central banks are “easing” by increasing the money supply by either lowering short term interest rate targets or more recently though various forms of quantitative easing, inexpensive capital becomes readily available. Private banks respond by flooding the financial system with capital via more loans and less stringent conditions on lending. The opposite happens when central banks tighten.

Margin lending is one of the most direct forms of access to capital for public market participants. Brokers lend customers money so they can buy additional securities. Traders in aggregate tend to take on greater margin during bull markets and less during bear markets. Brokers become less willing to take on smaller clients, reduce the margin they provide to larger clients, and decline to extend margin on more exotic securities in bear markets. This tightening of margin coupled with more stringent lending conditions and less bank lending to the economy overall create “liquidity crises” during recessions where there is less capital available overall to market participants.

Transaction costs

Compare the average commission of 4-6% a real estate broker charges in the USA with the average stock market commission of a fraction of a penny or free for most retail sized trades. (Its not really free as the brokers are selling your order) A $1m house could cost $60,000 to sell whereas $1m in stock may cost $10. You don’t frequently buy and sell your house or any real estate every year because in addition to not wanting to move, the transaction costs in the form of commissions and taxes are really high.

Transaction costs take the form of commissions, spreads or the difference between the buy and sell price, and taxes.

Commissions vary depending on the level of effort required to conduct a sale and the value added by the marketplace. Real estate has high commissions because property is different and requires different seller targeting. You are also effectively paying the agent for the time they spend marketing and getting tribal knowledge of a particular area and type of real estate. In the USA there are other factors at work that keep commissions high, but that is an article for another day.

Marketplaces that add significant value to buyers and sellers who would otherwise have much lower liquidity and greater transaction costs, such as Ebay and Amazon, can charge a hefty fee of around 15%. An oligopoly or monopoly market structure will result in even further transaction costs as sellers have no alternative to reach buyers. For example, in mobile apps, Android and Apple both charge 30% of the revenue (above $1m) that goes through their platforms.

The difference between the price people are willing to buy at or the bid and the price they are willing to sell at or the ask is called the spread. When you buy a large stock, it can be as low as 1 cent. However, if you try to buy a thinly traded small cap stock, ETF, or bond you are likely to face a much wider spread. The spread represents the market maker’s profit. They reduce their own risk of holding inventory in a security by charging a mark-up. A large capitalization security represents a lower risk to the traders as they can almost always exit their position near the market price whereas they have a higher likelihood of getting stuck in a smaller company. In a way greater liquidity begets more liquidity and vice versa. The lower volumes on smaller securities also makes it harder to make enough margin dollars so they have to make up for it with higher profits per trade.  During market dislocations where securities rapidly fall, spreads get larger as market participants seek to shield themselves from getting stuck with securities that are declining in value.  

Outside of securities trading there are also bid-ask spreads, but they are less formal. Try selling anything on Facebook marketplace and there will be a significant difference between what sellers are offering and what buyers are willing to pay.

Taxes can be a sneaky form of transaction costs that inhibit liquidity. Selling a collectible or gold results in a 28% long-term federal capital gain tax rate. Collectors and gold sellers may avoid larger auction venues or dealers where they are likely to get higher prices to avoid the capital gains tax, preferring instead to do unreported private sales. Low enough basis and high taxes may also inhibit sales period resulting in far less transactions than would normally occur. In addition to low interest rates, this is another reason less talked about reason why people are staying in their homes instead of selling.

Ease of transacting

How hard is it to sell a used car compared with a stock? An excavator located in Hawaii vs. a Microsoft bond? The ease with which someone can transact can make a market a lot more or less liquid. Unless you sell to a dealer directly at a large discount, selling a car to another person will still require a lot of time and effort. You have to list the car, deal with a ton of bogus or low ball offers, collect from the buyer, pay applicable taxes and fees, and do the required sales paperwork. Compare that with clicking a button on your screen to buy a stock.

Liquidity tends to increase when the ease of transacting improves. Stocks used to require calling a broker, paying a high commission, and looking up prices in the newspaper or a ticker tape. As everything became electronic and moved towards a single click, liquidity and transaction costs improved dramatically. Bonds are undertaking a similar process. Corporate bonds are still largely traded over the phone, but there are now several large exchanges that facilitate electronic trading.

Presence/absence of Market Makers

Market makers are traders that stand ready to buy or sell a given security. They try to make the spread or a small profit on each trade. Although high frequency traders have been given a bad name by Michael Lewis and others, they perform an important function as liquidity providers. Their presence increases the likelihood that you can buy and sell at closer to the market price than if they were not present. Prior to high frequency traders Specialists on the New York Stock Exchange (NYSE) performed a similar function. When market makers enter a market, overall liquidity tends to increase. For example, as major market makers have started trading in prediction and sports betting markets, volumes have exploded.

Policy Constraints

Governments around the world have put policies in place that have major implications for the liquidity of assets in their countries. Many countries place limits on foreign investors’ ability to purchase assets including stocks, majority shares in companies, and real estate, among others. Foreign investors who would otherwise represent a major source of liquidity are therefore limited from participating and overall liquidity is lower than it otherwise would be. Other countries such as China do the opposite, they constrain local investor’s ability to move capital overseas which results in higher liquidity and demand for domestic assets (with a lot of other negative implications).

Sanctions are one of the most extreme constraints. Western funds can’t hold Russian assets period, resulting in the absence of otherwise huge liquidity providers. A tanker owner can’t easily lease his ship to Iran or Venezuela without significant extra costs and legal/insurance risks. The otherwise extremely liquid market for tanker transportation is therefore highly illiquid for these two countries.

Counterparty risk

Would you sell a $1,000 gift card to a complete stranger on Reddit on the promise that they would pay you back? Unless you have recently walked out of an insane asylum, the answer is probably not. There is a high likelihood that the person on the other side of the sale will renege on their obligation to pay you. The risk that the other side of a trade fails to pay or deliver the agreed upon asset is called counterparty risk.

As an individual trading on virtually any major stock exchange the counterparty risk is minimal. However, the more esoteric the security or asset, usually the higher the counterparty risk and the lower the overall liquidity. Selling to anyone on credit results in higher counterparty risk so you are willing to sell less or on less favorable terms than you otherwise would. The opposite is also true, sellers will provide discounts for companies that pay upfront and eliminate the risk the buyer defaults on their payment obligation.  

Major market dislocations amplify major counterparty risk as banks and major traders may go under. For example, when oil prices went negative several smaller brokerages had clients become insolvent and failed to pay funds they were owed on trades. Other traders couldn’t get storage to take delivery of crude and tried to refuse delivery. Lehman brothers and Bear Stearns famously almost brought the whole financial system down when they became over leveraged and couldn’t meet their obligations.  

Implications

Think about liquidity before buying an asset. A security with very low liquidity such as an OTC stock may still have amazing upside, but assume that there is a chance you will not be able to sell it if you need to or will have to sell it at a much larger discount than the current price. The same logic applies even more to collectibles/art or any physical assets such as cars or homes. Liquidity can be a huge factor in determining whether an investment in a physical asset is worth undertaking or not. A $10,000 rare piece of art may not actually net you anywhere near $10,000 when you sell after commissions and there may not be any buyers at anywhere near your price when you are ready to sell.  

Liquidity is also a major factor in producing above market returns. Historically small cap value was one of the highest returning asset classes. This is partially due to small cap investors taking on greater liquidity risk than in large caps. You can make massive returns if you are a liquidity provider during market dislocations. When there is blood on Wall Street having liquidity lets you buy assets on the cheap partially because few parties have the liquidity to take advantage of the distress. In the most extreme cases, providing liquidity to a bankrupt firm that successfully turns itself around will return multiples of your original investment.