How Liquidity Affects Market Efficiency  

Liquidity refers to how easily an asset can be bought or sold with a minimum impact to its value. If a market has high liquidity, investors have the ability to buy or sell assets quickly and easily, as the assets are regularly traded and there are always sufficient numbers of willing sellers and buyers. A closely related concept is the “depth” of a market. If a market is deep, investors can trade large volumes without substantially affecting the price of an asset.

A highly liquid market is also a deep one—they both indicate a balance of willing participants in the market. Liquidity and depth are crucial to a market’s efficiency because they allow for immediate execution of trades and also for corporations and government agencies to raise large amounts of long-term capital quickly and cost-effectively.

In 2007, a number of companies found themselves in a liquidity crisis. Investors had lost confidence in the value of certain securities, particularly securities that were not regularly traded in an active market. As a result, there were an insufficient number of buyers to match the higher number of sellers. Many traders had to sell these illiquid assets at a loss.

Continue reading about Industry Basics: Investment Risk in Capital Markets.