Liquidity

Market liquidity refers to how easily an asset can be traded at its fair market value without causing a significant impact on the market.

One of the simplest ways to quantify liquidity is by examining the implementation shortfall (or slippage) of executing a trade. If trading a given amount of an asset incurs minimal slippage, that asset is considered liquid. Essentially, liquidity reflects the execution risk of trading the instrument—the more liquid the asset, the less risk in executing a trade at the desired price.

Cash is the most liquid asset, as it can easily be converted into other assets. Highly liquid assets also include short-term U.S. Treasuries and money market funds, while other assets vary in liquidity depending on how easily they can be traded.

An instrument with a tight bid-ask spread tends to be more liquid because trades can occur with less slippage. Conversely, higher volatility can lead to wider spreads, reducing liquidity since market makers adjust for increased risk. This explains the saying, "prices crash in the absence of liquidity," as reduced liquidity makes it harder to execute trades without moving the market.

One way to assess the liquidity of an asset is to follow the convention In financial accounting, where assets are categorized into Level 1, Level 2, and Level 3 based on their ease of valuation:

• Level 1 assets (e.g., stocks and bonds) are the most liquid and easiest to value using market prices.
• Level 2 assets are less liquid, harder to value, but can still be priced based on observable market inputs.
• Level 3 assets are the least liquid and hardest to value, often requiring complex models or assumptions.

Note that these asset levels are unrelated to L1, L2, and L3 market data, which refer to the granularity of the market data.

While a tight bid-ask spread often suggests higher liquidity, it's not a guaranteed measure. For example, an asset with a wide spread but deep market depth at the best bid and offer may be more liquid overall for larger trades than an asset with a tight spread but low depth. Similarly, liquidity is not solely about visible orders—an instrument with low visible depth may still be more liquid if the spread replenishes consistently, preventing significant slippage as orders are executed.

Another misconception is that passive limit orders (orders that wait for the market to reach them) always provide liquidity, while aggressive limit orders (orders that cross the spread) remove it. However, in a market with many passive orders but no trading activity, liquidity would be considered low. Active markets where aggressive orders frequently cross the spread can provide more liquidity due to the higher trading volume, as it becomes easier to execute trades without significant slippage.

The implementation shortfall definition offers a more comprehensive view of liquidity, considering all these factors—spreads, market depth, volatility, and execution strategies—to give a clearer understanding of an asset’s true liquidity.