The world of finance is composed of assets, markets and participants. It's the dialogue between each facet that facilitates the process of price discovery. However, without base levels of liquidity and participation, efficient asset pricing grinds to a halt.
Read on to learn more about illiquid assets and what they mean to active traders and investors.
What Is An Illiquid Asset?
An illiquid asset is a good or service that is not readily convertible to cash. These items are the opposite of liquid assets, which may be exchanged for currency quickly and easily.
According to the US Securities and Exchange Commission (SEC), illiquid investments are:
"An illiquid investment is an investment that is not reasonably expected to be sold in current market conditions in seven calendar days without significantly changing the market value of the investment."
As a general rule, the less liquid asset classes and securities are, the less attractive they are to mutual funds, traders and investors. While this guideline may not be the cornerstone of every investment strategy, it plays a vital role in many financial decisions.
Examples Of Illiquid Assets
Contrary to a liquid asset, an illiquid asset is not ideal for generating a steady cash flow. Below are two primary categories of illiquid assets:
1. Illiquid Investments
An illiquid investment is something that is not easily sold after purchase. Examples of illiquid investments are exotic collectibles, real estate or other alternative investments.
2. Illiquid Securities
Illiquid securities are stocks, bonds, currencies, cryptos or derivatives that feature a lack of buyers and sellers. An illiquid security exhibits a "thin" market and a relatively low trading volume. Examples of illiquid securities are over-the-counter (OTC) micro cap stocks and complex debt instruments (forwards, swaps).
Challenges Of Market Illiquidity
According to the San Francisco Federal Reserve, liquidity risk is defined as follows: "liquidity risk is the risk that a firm will not be able to meet its current and future cash flow and collateral needs, both expected and unexpected."In other words, liquidity risk is the probability that an entity will fall victim to insolvency.
However, in the financial markets, the impact of illiquidity is a bit different. Instead of a counterparty defaulting on obligations, a disequilibrium of buyers and sellers develops. The result is limited market depth and enhanced risk exposure.
The higher risk profile associated with illiquid markets is largely due to three factors: wide bid-ask spreads, increased slippage and disjointed price action.
1. Wide Bid-Ask Spreads
A bid-ask spread is the difference between the ask (offer price, sell) and bid (purchase price, buy) facing an asset. Bid-ask spreads are used in determining the current market price of an asset and represent the transaction costs of buying or selling said asset on the open market.
An illiquid asset has either a lack of buyers or sellers, so bid-ask spreads are typically very wide. A greater distance between a bidding price and asking price signifies lagging market depth; there aren't buyers and sellers at every price point. This poses a higher risk to the trader as the wide spread must be overcome to secure a profit.
To illustrate the impact of a wide bid-ask spread, assume that Trader A is looking at two trades: buying 1 lot of EUR/USD or buying 1 lot of GBP/USD. The EUR/USD is trading at 1.0000 with a spread of 1 pip; on the other hand, the GBP/USD is trading at 1.2000 with a spread of 3 pips. If Trader A buys the GBP/USD, price must rally past 1.2003 to become profitable. Conversely, the EUR/USD only has to move to 1.0002 to generate a gain. The difference in bid-ask spreads furnishes the trader with a greater assumed risk.
In the live market, the greater the bid-ask spread, the more expensive the trade. That's why many retail and institutional investors direct their capital toward liquid investments with tight spreads.
Slippage occurs when an order is filled at the market at a different price than specified. The result can be a gain (price improvement) or a significant loss. Slippage is prevalent in thin, illiquid markets.
To illustrate the impact of slippage, let's say that Trader A is looking to buy the exotic Canadian dollar/Singapore dollar pair (CAD/SGD). Upon the pair hitting 1.0547, Trader A submits a market order to buy 1 lot of CAD/SGD; because there are fewer sellers of CAD/SGD, Trader A's buy market order is filled at 1.0552, five pips from the intended price. Although this is unfortunate for Trader A, the market deemed it a fair price as 1.0552 was the best available market price.
When trading illiquid markets, it's important to perform adequate due diligence. For instance, limit orders may be used to secure market entry/exit while reducing slippage. In the case of Trader A, a buy limit at 1.0547 could have saved five pips in slippage cost.
3. Disjointed Price Action
As mentioned, illiquid markets feature a reduced number of buyers and sellers. This relative lack of participation undermines efficient trade and the process of price discovery. Accordingly, short-term volatility can become extreme, driving an asset's market value quickly directional.
Shares traded on the OTC stock market are especially prone to this phenomenon. These off-stock exchange offerings are renowned for their small floats, vague reporting and limited participation. In fact, the SEC has concluded that OTC stocks "tend to be highly illiquid" and generate "volatile investment returns on average."
In the event that a large buy or sell order hits the market, an OTC stock's valuation can quickly change. Sometimes this generates higher returns for the traders; other times it leads to crushing losses.
Illiquid assets are those that are not readily convertible to cash. Fine art, real estate and rare collectibles are a few examples of illiquid assets. An illiquid market is one that features limited depth and participation. The result is inefficient price discovery due to wide bid-ask spreads, increased slippage and disjointed price action.
When dealing with illiquid assets and markets, an enhanced risk profile does exist. Ultimately, it's up to the individual to decide if such assets and markets are viable avenues of investment or trade.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.
Retrieved 16 Jul 2022 https://www.sec.gov/divisions/investment/guidance/secg-liquidity