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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.


Comments: (2)

A Finextra member
A Finextra member 20 January, 2012, 15:20Be the first to give this comment the thumbs up 0 likes

What is it when greedy bankers sell things they don't own at all or own yet?  Is that Short Selling.   Or when an investment fund promises a golden return but simply funds the return from new buys deposits?  That's a ponzi system, that's what.

When banking was about real gold and real notes, it was easy to track. Now it is about electronic money and transfers of numbers on a balance sheet - so easy to fiddle (shouldn't be though).  Its been fiddled for so long there was a huge hole waiting for us to fall in it.  Now the public is being asked to fill that hole while banking goes off to dig new ones. 

The pursuit of money has ever been a dirty one - fighting wars, plundering, robbing, fraud.   Legitimate business makes money selling a product for more that it costs to produce (doh) or simply selling something for more than it costs to buy (including shorting).

Anyway - surely there will be illiquidity when noone wants to sell (perhaps because they would be losing by selling).  Or when noone wants to buy because they have no customers to sell to?  Would that be a sign of a stagnant market.

There was once (supposedly) so much product (e-money) in the system that bankers were throwing it about cheaply.  That was excess liquidity.  I suggest that there simply was not that amount of money in the system and it was a giant accounting fraud and ponzi system in motion.  Where did it go?  It wasn't simply wiped off the value of stocks and shares.  And there's a big banking industry that just wants to brush it away and get back to doing things the same way?

No wonder banker bashing is popular. 

I will post this anonymously becuase I simply present this as Devils Advocate.

Gary Wright
Gary Wright 20 January, 2012, 15:44Be the first to give this comment the thumbs up 0 likes

I can tell you're a tad upset but also agree with some of your points. In my view Short Selling is a risky business and should be restricted to market makers who use their own balance sheet. Not some poor investor ignorant of the risks.

Market makers supply liquidity to the market. So when no investor is buying or selling the market maker will. This is suplying liquidity and what Jobbing was before Big Bang and the Banks took advantage

For suplying liquidity and risking their money market makers should be the only business that can sell short or borrow stock. A return to pre Big Bang. At a stroke this would eliminate all the leveraged products like hedge funds and other derivatives which cause so much volatility and in fact reduce liquidity.

But that wont be popular but would at least put the market back in to balance and create a business that most people will understand.

Do the politicians have the guts to do it?

Gary Wright

Gary Wright


BISS Research

Member since

19 Sep 2007



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Post-Trade Forum

The Post Trade Forum's aim is to propagate debate and discussion between senior practitioners in Post Trade Operations in the global securities market; to bring about increased awareness and knowledge across both buy-side and sell-side financial institutions in financial products and be a focal point for firms and practitioners to air views.

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