In business, economics or investment, market liquidity is a market’s ability to facilitate an asset being sold quickly without having to reduce its price very much (or even at all).
Equivalently, an asset’s market liquidity (or simply “an asset’s liquidity”) is the asset’s ability to sell quickly without having to reduce its price very much.
Liquidity is about how big the trade-off is between the speed of the sale and the price it can be sold for. In a liquid market, the trade-off is mild: selling quickly will not reduce the price much.
In a relatively illiquid market, selling it quickly will require cutting its price by some amount. Money, or cash, is the most liquid asset, because it can be “sold” for goods and services instantly with no loss of value.
There is no wait for a suitable buyer of the cash. There is no trade-off between speed and value. It can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs. If an asset is moderately (or very) liquid, it has moderate (or high) liquidity.
In an alternative definition, liquidity can mean the amount of highly liquid assets.
If a business has moderate liquidity, it has a moderate amount of very liquid assets. If a business has sufficient liquidity, it has a sufficient amount of very liquid assets and the ability to meet its payment obligations.
An act of exchanging a less liquid asset for a more liquid asset is called liquidation. Often liquidation is trading the less liquid asset for cash, also known as selling it.
An asset’s liquidity can change. For the same asset, its liquidity can change through time or between different markets, such as in different countries.
The change in the asset’s liquidity is just based on the market liquidity for the asset at the particular time or in the particular country, etc. The liquidity of a product can be measured as how often it is bought and sold.
Liquidity is defined formally in many accounting regimes and has, in recent years, been more strictly defined. For instance, the US Federal Reserve intends to apply quantitative liquidity requirements based on Basel III liquidity rules as of fiscal 2012.
Bank directors will also be required to know of, and approve, major liquidity risks personally. Other rules require diversifying counterparty risk and portfolio stress testing against extreme scenarios, which tend to identify unusual market liquidity conditions and avoid investments that are particularly vulnerable to sudden liquidity shifts.